Diversification means spreading your money across different investments so one bad outcome does not ruin your whole portfolio. It matters because every investment has risk, including the chance of losing value or earning less than expected. A diversified portfolio can help smooth out ups and downs over time.
The main idea is simple: do not put all your money in one place.
Key Facts
- Portfolio weight = amount in an asset / total portfolio value
- Portfolio return = w1r1 + w2r2 + w3r3 + ...
- Diversification lowers unsystematic risk, which is risk tied to one company or sector.
- Systematic risk affects the whole market and cannot be fully removed by diversification.
- Rebalancing means adjusting investments back to target weights, such as 60% stocks and 40% bonds.
- Risk and return are connected: higher expected return usually comes with higher uncertainty.
Vocabulary
- Diversification
- Diversification is the strategy of spreading investments across different assets to reduce the effect of any single loss.
- Asset class
- An asset class is a category of investments, such as stocks, bonds, cash, real estate, or commodities.
- Portfolio
- A portfolio is the collection of investments owned by a person or organization.
- Risk tolerance
- Risk tolerance is how much investment uncertainty or loss an investor is willing and able to accept.
- Rebalancing
- Rebalancing is the process of buying or selling investments to return a portfolio to its planned mix.
Common Mistakes to Avoid
- Owning many stocks from the same industry, because this is not true diversification if all of them react to the same news or economic trends.
- Ignoring asset weights, because a portfolio with 90% in one investment is still highly concentrated even if it contains several other small holdings.
- Chasing recent winners, because investments that performed well recently can still fall and may already be overpriced.
- Never rebalancing, because market changes can shift your portfolio away from your original risk level and financial goals.
Practice Questions
- 1 A student has $1,000 to invest and wants 50% in stock funds, 30% in bond funds, and 20% in cash. How many dollars should go into each category?
- 2 A portfolio is 60% in a stock fund that earns 8% and 40% in a bond fund that earns 3% over one year. What is the portfolio return?
- 3 Explain why owning five different technology stocks may be riskier than owning a mix of technology stocks, bond funds, and cash.