Diversification Strategy (Investments) - Explained
What is a Diversification (Finance) Strategy?
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What is Diversification in Finance?
Diversification is a strategy to minimize the risk by diversifying the investment in various sectors. It is allocating the fund in various ways, including separate financial institutions, diverse industries, and investment type. Ideally, eat of these categories respond differently to the same event, thus when one sector goes down, your money is secure with others. Diversification aims at reducing the non-systematic risk in a portfolio.
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How Does Diversification Work?
Diversification, of course, cannot guarantee against loss; but, the experts agree that it is an effective strategy to reach the long-term financial aim of reducing risk. Data shows that maintaining a well-planned, diversified portfolio with a multitude of investment instruments (such as stock and bonds) is the key to optimizing a diversification plan.
For example, bonds and stocks generally do not react in the same way to an unfavorable market event. Investing in foreign securities is also a good practice for maximizing the benefits of diversification. Domestic investments do not always react similarly to foreign securities when the US economy faces a crisis. It is also important to invest across different types of industries, as the same (or similar) industries might react similarly to a particular event. Statistically, your investments need to be as uncorrelated as possible in terms of price and demand.
Diversification is not limited to the investment sector. Other industry actors, such as banks and investment companies, also follow a strategy of diversification to minimize their risks and, in some cases, earn higher returns.
Banks spread their asset to a large cross-section of diversified borrowers. It helps them to maintain or increase their earnings without affecting the level of exposure. Investment companies often enter various markets or industries that are different or unique in their core businesses. This technique minimizes the risk of depending on a single or few sources of income. By entering a new industry, they also ensure to cater to different markets by producing diverse merchandise and avoid cyclical instability.