Diversification, Diversification, Diversification

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If the three most important things about investing in real estate are location, location and location, then the three most important things about investing in equities are diversification, diversification and diversification.

What Is Diversification?

Diversification is a basic tenet of investing. But what is diversification?

According to Dictionary.com, diversification is defined as:

1. the act or process of diversifying; state of being diversified.
2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc. so that a failure in or an economic slump affecting one of them will not be disastrous.

The key phrase about diversification listed above is: “…so that a failure in or an economic slump affecting one of them will not be disastrous.” In other words, don’t put all of your eggs in one basket.

Mutual Funds and Diversification

Diversification is one of the many advantages of investing in mutual funds. When it comes to diversification, mutual funds can help an investor in two ways. First, the beauty of mutual funds is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy individual securities, which exposes you to more risk. In other words, a mutual fund allows an investor to diversify into many different stocks for a nominal investment.

Sometimes, when it comes to diversification, it’s not good enough to simply own many different stocks. For example, if you own 100 stocks within a mutual fund, and those 100 stocks are in the financial sector (a sector mutual fund), more than likely as the financial sector moves up and down, so does the value of your mutual fund. That brings us to the second point. A mutual fund also allows for diversification between various styles, sectors, countries, and, well, you name it. You can either buy a mutual fund that is broadly diversified, or you can buy a portfolio of mutual funds across various sectors — creating your own diversification.

Risk, Reward and Diversification

In summary, a mutual fund allows for diversification between many different stocks and also allows for diversification between various sectors, styles, etc. This diversification allows investors to reduce the risk of one particular stock or sector, but also allows for more potential reward by offering a broader exposure to various stocks and sectors.