Diversification free essay sample

Consider, for example, an investment that consists of only the stock issued by a single company. If that companys stock suffers a serious downturn, your portfolio will sustain the full brunt of the decline. By splitting your investment between the stocks of two different companies, you reduce the potential risk to your portfolio. Another way to reduce the risk in your portfolio is to include bonds and cash. Because cash is generally used as a short-term reserve, most investors develop an asset allocation strategy for their portfolios based primarily on the use of stocks and bonds. It is never a bad idea to keep a portion of your invested assets in cash, or short-term money-market securities. Cash can be used in case of an emergency, and short-term money-market securities can be liquidated. Instantly in case an investment opportunity arises, or in the event your usual cash requirements spike and you need to sell investments to make payments. Also keep in mind that asset allocation and diversification are closely linked concepts; a diversified portfolio is created through the process of asset allocation. When creating a portfolio that contains both stocks and bonds, aggressive investors may lean toward a mix of 80% stocks and 20% bonds while conservative investors may prefer a 20% stocks to 80% bonds mix. Regardless of whether you are aggressive or conservative, the use of asset allocation to reduce risk through the selection of a balance of stocks and bonds for your portfolio is a more detailed description of how a diversified portfolio is created than the simplistic eggs in one basket concept. With this in mind, you will notice that mutual fund portfolios composed of a mix that includes both stocks and bonds are referred to as balanced portfolios. The specific balance of stocks and bonds in a given portfolio is designed to create a specific risk-reward ratio that offers the opportunity to achieve a certain rate of return on your investment in exchange for your willingness to accept a certain amount of risk. In general, the more risk you are willing to take, the greater the potential return on your investment. What Are My Options? If you are a person of limited means or you simply prefer uncomplicated investment scenarios, you could choose a single balanced mutual fund and invest all of your assets in the fund. For most investors, this strategy is far too simplistic. While a given mix of investments may be appropriate for a childs college education fund, that mix may not be a good match for long-term goals, such as retirement or estate planning. Likewise, investors with large sums of money often require strategies designed to address more complex needs, such as minimizing capital gains taxes or generating reliable income streams. Furthermore, while investing in a single mutual fund provides diversification among the basic asset classes of stocks, bonds and cash (funds often hold a small amount of cash from which to take their fees), the opportunities for diversification go far beyond these basic categories With stocks, investors can choose a specific style, such as focusing on large caps, mid caps or small caps. In each of these areas are stocks categorized as growth or value. Additional choices include domestic stocks and foreign stocks. Foreign stocks also offer sub-categorizations that include both developed and emerging markets. Both foreign and domestic stocks are also available in specific sectors, such as biotechnology and health care. In addition to the variety of equity investment choices, bonds also offer opportunities for diversification. Investors can choose long-term or short-term issues. They can also select high-yield or municipal bonds. Once again, risk tolerance and personal investment requirements will largely dictate investment selection. While stocks and bonds represent the traditional tools for portfolio construction, a host of alternative investments provide the opportunity for further diversification. Real estate investment trusts, hedge funds, art and other investments provide the opportunity to invest in vehicles that do not necessarily move in tandem with the traditional financial markets. These investments offer yet another method of portfolio diversification. The Importance of Diversification:- Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing into different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here we look at why this is true, and how to accomplish diversification in your portfolio. Different Types of Risk Investors confront two main types of risk when investing: Undiversifiable Also known as systematic or market risk, undiversifiable risk is associated with every company. Causes are things like inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to a particular company and/or industry, and it cannot be eliminated or reduced through diversification; it is just a risk that investors must accept. Diversifiable This risk is also known as unsystematic risk, and it is specific to a company, industry, market, economy or country; and it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that your assets are not all affected the same way by market events. Why one should Diversify Lets say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks would drop. Your portfolio would witness a noticeable drop in value. If, however, you counterbalanced the airline-industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stocks prices would climb as passengers turn to trains as an alternative form of transportation. But you could diversify even further since there are many risks that affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies statisticians would say that rail and air stocks have a strong correlation. Therefore, to achieve superior diversification, you would want to diversify across not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better. But its also important that you diversify among different asset classes. Because different assets such as bonds and stocks will not each react in the same way to adverse events, a combination of asset classes will reduce your portfolios sensitivity to market swings. Generally, the bond and equity markets move in opposite directions, so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another. There are additional types of diversification and many synthetic investment products have been created to accommodate investors risk-tolerance levels; however, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market. Unfortunately, as the world has seen cases of fraud and earnings manipulation, even the best analysis of a company and its financial statements cannot guarantee that it wont be a losing investment.