Diversification: Meaning & Example

A risk management strategy that mixes a wide variety of investments within a portfolio.

Detailed Explanation

Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and pose a lower risk than any individual investment found within the portfolio.

Real-World Example

Instead of investing all your money in a single tech stock like Tesla, you diversify by buying a Broad Market Index Fund that holds 500 different companies across tech, healthcare, energy, and retail. If tech stocks crash, your healthcare and energy stocks might go up, balancing your portfolio.

Key Takeaways

•Diversification is often called 'the only free lunch in investing'.
•It minimizes the risk of catastrophic loss from a single company going bankrupt.
•True diversification requires investing in assets that are not highly correlated.

Related Terms

Asset Allocation Mutual Fund