Diversification is the term used in the context of financial markets and it refers to that method through which an individual or a company can reduce the risk of losing money by allocating the investments across various financial assets. Given below are some examples of diversification among various asset classes –
- In stock market suppose you like information technology sector and you want to want to invest $15000 and if you are not looking for diversification then you can invest the whole amount into buying a single stock with that amount, however if you are looking for diversification then you can buy 3 or 4 stocks of information technology companies. Hence you can invest $5000 each into three stocks that is Accenture, Google and Microsoft, now suppose some problem happens in Microsoft Company then if you had invested the whole amount into Microsoft then you would have ended up losing money however if your investments are diversified then your loss would be only on $5000 and not on $15000.
- In mutual funds if one invest into only equity growth fund then there is a risk that in case the market crashes then it will result in loss for investor, however if the same investor had invested the funds in debt fund also then risk of loss arising out of market crash would be mitigated.
- In case of real estate suppose a person has $100000 and he or she buys only residential property with that amount then there is risk that property price may fall, however if the investor buys $70000 worth of residential property and $30000 worth of commercial property then chances of loss reduces because price of commercial property and residential property never rise and fall in same manner.
- In case of foreign institutional investor who invest money across countries and if the investor invest the whole amount into one country then he or she is exposed to risk, however if the same investor had invested the money in multiple countries then the risk is reduced to considerable extent.
- During merger and acquisition when a company is looking for potential target company then also it can take benefit of diversification, suppose a company which is into business of manufacturing of mobile and has excess cash then with that cash it can either buy another mobile company or it can go for diversification and buy television company so if market for mobile is in downturn it won’t affect the company that much because it will make profit out of television segment of its business.
As one can see from the above the main idea behind diversification is that one should not keep all the eggs in one basket and then repent that all eggs are broken rather one should keep those eggs in different locations so that some eggs remain safe. Diversification is simple to understand but difficult to implement as people get carried away by greed when an asset class is in bubble and invest the whole amount into that assets class and then repent later.