Diversification is one of the most important techniques in financial planning and investment. It is basically not putting all your eggs in one basket and hence aims to maximize return by investing in different areas that are likely to react differently to various market and economic changes.
There are a number of different financial instruments available for investing like stock markets, mutual funds, bonds, gold, real estate, etc. and a diversified portfolio neatly divides your assets into more than one asset class in order to reduce risk and maximize profits.
Although it does not guarantee against loss, it is the most well-sorted way of reaching long-term financial goals while minimizing risk.
Generally, the bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, volatility in one will likely be offset by positive results in another. A combination of asset classes should reduce your portfolio’s sensitivity to market swings.
For instance, in the case of a booming economy, equity markets outperform bonds while gold prices also decrease, however, when the economy slows down or in case of an unprecedented event, investors move towards safe haven instruments like gold and also bonds often perform better than stocks.
So, in such an event, if an investor's portfolio only has stocks, it is likely to be in loss, but in the case of a diversified portfolio, a rise in bonds and gold prices will cap those losses.
So say the stocks markets declined 10 percent, bonds and gold would keep your portfolio from falling as far. And hence, diversification is important in your investments.
Similarly in terms of stocks, if a portfolio only has auto stocks and due to some new regulations or raw material price hikes, the auto stocks have been under pressure, so will be the portfolio. But say it also has metals, which has seen a global increase in prices. This might counterbalance your losses.
Therefore, one must diversify across the board, not only different types of companies but also different types of industries. The lower the correlation of your stocks, the better.
While investing, one must also be sure that a temporary downside can be handled. Equity investments can be done through mutual funds instead of the direct purchase of individual stocks. This also acts as a buffer in case if a particular stock tank, there are others to make up for it or at least trim the losses.
Therefore, one must always look for various avenues to invest in and not just put all money in one stock or scheme.