Definition: Diversification is a risk management strategy that involves spreading investments across various financial instruments, industries, and other categories to optimize returns and reduce the impact of a single security or sector. The primary aim of diversification is to limit exposure to any one asset or risk.
Usage in Finance: In finance, diversification is commonly practiced in portfolio management where it’s used to balance risk and reward by allocating a portfolio’s assets according to the individual’s goals, risk tolerance, and investment horizon. The benefits of diversification are primarily that it can help to minimize the risk of catastrophic losses.
Types of Diversification: Diversification strategies can involve different asset classes (stocks, bonds, commodities), sectors (technology, healthcare, manufacturing), geographical regions (domestic, international, emerging markets), and investment styles (value, growth, income).
Theoretical Background: The concept of diversification has been formalized in the Modern Portfolio Theory (MPT), which demonstrates mathematically that portfolio diversification can reduce investment risk. According to MPT, an ‘efficient’ portfolio is one that has the highest expected return for a given level of risk.
Limitations: While diversification can help reduce unsystematic risk (risk that is specific to a single asset or a small group of assets), it cannot protect against systematic risk (risk that affects a large number of assets). Also, there is a point of diminishing marginal returns to diversification; after about 20-30 securities, the benefit of adding more securities to your portfolio is minimal.
Related Terms: Asset Allocation, Portfolio Management, Risk Management, Modern Portfolio Theory.
Please note that while diversification can help spread risk, it does not assure a profit, or protect against loss, in a down market. Always consult with a qualified professional before making any investment decisions.