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Monday, February 11, 2013

Why Stock Diversification is Important?

Stock Diversification means buying stock in a range of different industries.

On the face of it, diversification ought to be simple: You don't put all your investing eggs in one basket because if you drop it, all the eggs will break!

But it's not that easy. Suppose you don't invest all your available capital in one stock. Suppose you buy two. Are two baskets enough? And which eggs go in which baskets?

No, not so simple indeed. But it's important to figure out because diversification allows investors to reduce risk in their portfolios without giving up any return.

The idea is that, because you cannot possibly know which stocks will perform better or worse than average, you cannot afford to put all your money into one company, or even in companies within a single industry.

You have to spread the risk and the opportunity.

Diversification of investment holdings is the most important shield against risk. Because some investments rise in value while others fall, diversification smoothes out much of the volatility of the overall return from a portfolio. Diversification sacrifices some of the upside potential, but this should be more than offset by the benefits of a lower level of risk.

The trade-off for the balancing of risk and return in a diversified portfolio is that your overall return might be somewhat lower than you could get in an undiversified portfolio. However, along the way, a diversified portfolio will have less volatility, and steadier returns.

The Point is: Don't put all of your eggs in one basket.

Only by diversifying you will be able to realize your average return objective with lower risk. The right level of diversification for you at a given time depends on a variety of factors, including where you are financially, what your goals are, and what the market is doing.

Though literally everyone talks about diversification for their investment portfolio, very few understand the true statistical data underlying the definition. As a result, the majority of portfolios are not properly diversified and an extended risk is being taken, unquestionably unwittingly, but nonetheless evident, by most investors.

In order to cope with the above problem, you have to understand the following:

1. Systematic Risk: This is a risk due to the movement of the market itself. The benchmark could be any Index. If you have one or a few investments in a given area, you could compare its return to that of the benchmark index to determine how well it is doing.

2. Unsystematic Risk: This is the risk of a single company causing a significant move, either up or down. This is usually the risk that most investors would want to eliminate, unless they are "true risk takers!" This risk may be tempered and in fact virtually eliminated, by the purchase of an increased number of stocks.

3. Time Risk: It is usually known that the longer one holds an investment, the less the overall risk. It means that sometimes if you have a risky stock, risk would lower the longer the stock was held.

Proper diversification is the foremost issue in all efficient investments, especially where individual stocks are purchased. It is impossible to properly judge a portfolio if the risk factor is missing. And even if you do understand your holdings, it is mandatory that you must "know your self", and therefore have detailed knowledge of all your investment assets in order to be able to determine the proper diversification and risk.

The importance of Professional Investment Guidance, regardless the performance of the market, cannot be overstated. A qualified financial consultant can assist you with portfolio review and to discuss strategies for achieving your financial goals.

By understanding the basics of investing, working with a professional to design an appropriate portfolio, and allowing your investments time to grow, you can invest successfully.