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What Is Diversification in Investing?

A new investor asks Money Girl: “What is diversification and why is it so important?”

By
Laura Adams, MBA
October 26, 2012

What Is Diversification in Investing?

by Laura Adams

A Money Girl podcast listener named Nancy H. asks:

“I’m a recent college graduate just getting started investing. I keep hearing that my investments should be diversified. What is diversification and why is it so important?”

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ANSWER:

Having investments that are diversified simply means that you own many different kinds that are not related to one another.

If you invest all your money in one U.S. stock, for instance, your return depends completely on what happens to that one stock—which is very risky.

However, if you add several other unrelated investments—such as international stocks, bonds, real estate, and commodities—to your portfolio, what happens to that one U.S. stock isn’t as important.

Diversification prevents you from “putting all your eggs in one basket,” financially speaking. It severely reduces the possibility that you could lose everything all at once.

You should diversify among the major asset classifications—such as stocks, bonds, and cash—because economic conditions affect each of them very differently. But you should also diversify within each of those asset categories.

For instance, stocks can be broken down into domestic, international, value, and growth groups. There are different kinds of bonds, such as government, corporate, and international.

Diversifying investments into many different kinds of securities helps reduce risk without sacrificing your potential returns.

Find out how to choose the right investments and build a winning portfolio, by reading or listening to the audio podcast version of How to Invest in the Perfect Portfolio.

Other Articles and Resources You Might Like:
Mutual Fund Fees—How Much Is Too Much?
How to Save for Retirement on Less Income
Can I Protect Investments from a Failed Brokerage?
Investment Tips: How and Where to Invest (the Easy Way!)

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