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Diversification is a basic concept that’s critical to building a portfolio able to withstand the test of time. It is the process of spreading your money among a variety of securities to reduce exposure to any one investment or asset class. The premise behind diversification is easy to grasp: When you diversify across a range of investments, you may reduce risk by creating the potential for better performers to compensate for poor performers.

Effective diversification involves more than simply owning a jumble of different investments. It means selecting a mix of securities that may not react the same to a given set of conditions — investments that carry a low “correlation” to one another. Correlation is a statistical measure of the degree to which two securities perform the same under particular market conditions. For instance, if you choose stocks of two companies that make the same product and serve the same market, chances are that they will move in tandem when conditions affecting their industry change. Owning both would be unlikely to lower risk in your portfolio. Alternatively, owning stocks of companies that operate in different segments of the economy may help improve your risk-adjusted return, although past performance is no guarantee of future results.

Diversifying by Industry
Combining stocks from different industries or sectors — financial services, telecommunications services, and health care in this case — may potentially result in a portfolio that has less risk than the individual industries or sectors. Of course, the portfolio may also have somewhat lower returns than some of the individual industries or sectors — a trade-off that long-term investors may be willing to make.

Filed under: Financial Planning