Why Diversify?

Investment managers frequently discuss the concept of portfolio diversification. Unfortunately, they rarely explain what this means. Diversification can be...well...rather diverse. Let's consider the basic principles surrounding diversification. For starters, markets tend to be cyclical which is why when the stock market is soaring, the bond market could be collapsing. Also, rarely do security prices move in tandem. In other words, it's unlikely that stocks bonds, commodities, real estate, etc. would all move up or all move down at the same time.


A diversified portfolio contains securities from different classes. For example, a well-diversified portfolio might include a mix of commodities, stocks, bonds, and real estate. The purpose of this strategy is twofold. First, diversification allows an investor to manage risk. If one asset class is collapsing, another might increase. For example, during stock market crashes, gold prices often rise as investors look for safety. The increases in gold prices can offset the drop in stock prices. Second, a diversified portfolio allows an investor to cash out of an asset class when it peaks and reallocate funds to undervalued assets. If gold is nearing a top, an investor might choose to sell gold and buy beaten down stocks.


While portfolio diversification sounds simple in principle, it can be fairly complicated. Knowing which asset classes to buy and when to buy them is often best left to the experts.


Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.

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