Why Diversification Is Important in a Portfolio

If you're new to stock investing, you may be wondering why diversification is important in a portfolio. For first-time investors, diversification probably doesn't seem terribly important; isn't it better, after all, to put all your money in one stock so it'll pay off big time? Unfortunately, putting all your eggs in one basket can also result in big-time losses, so consider a strategy of diversification before you invest in any stocks.

What Diversification Means
If you're not familiar with the term, diversification means to invest in multiple stocks across different market segments, instead of putting all of your money into a single stock or single market segment. Diversification can be accomplished in a few ways; either by purchasing multiple stocks in different segments, by investing in an index fund that spans market segments or via mutual fund diversification.

It's important to note for the purposes of diversification that investing in index funds and mutual fund diversification involve two different approaches to the stock market; index funds follow broad market indexes, while mutual fund diversification is based on a managed, hand-picked fund that may not be as broad in scope as an index fund. Therefore, depending on the fund's investments, a mutual fund may not utilize the principles of diversification effectively.

The Benefits of Diversification
If you're wondering why diversification is important in a portfolio, the answer lies in the performance of individual market segments. If you invest in only a single stock or stocks in a certain market segment, you're vulnerable to fluctuations in that market segment. For example, people who invested solely in dot-com startups had a nasty turn in 2001 when the bubble collapsed, but those who practiced diversification didn't lose everything.

The key benefit of diversification is that, even if a portion of your portfolio suffers performance issues, you don't lose your entire investment. By spreading your investment across multiple market segments, you help insulate yourself against market fluctuations. However, diversification can't protect you from everything, as your portfolio will go down if the market itself goes down.

The Differences Between Horizontal and Vertical Diversification
Diversification across the stock market is a well-known investment strategy. However, if you're still not sold on why diversification is important in a portfolio, consider the different types of diversification: horizontal diversification and vertical diversification. Horizontal diversification is the process of spreading your risk across one type of investment, such as the stock market.

Vertical diversification, on the other hand, is investing across multiple security types, including stocks, bonds, mutual funds, cash and other short-term investments. Vertical diversification protects not only against performance in the stock market but also against overall economic changes. If the stock market goes through a long bear period but you've got other investment types, your portfolio won't suffer as much as if you'd invested only in the stock market.

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