Importance of Diversification in Stock Market

NEW YORK, November 21 (FinanceEnquiry.com) – The concept of diversification seems to be simple, as the saying goes ‘don’t put all your eggs in one basket’ because if you drop it all the eggs will break.  However, it’s not that simple, diversification means buying stocks in range of different industries and not investing all your capital in one stock, it is difficult to ascertain which egg goes in which basket.  It is essential for an investor to find the solution as diversification helps investors to reduce risks in their portfolios without giving up the returns. The underlying reason behind the theory is that an investor cannot possibly know that which stock will perform better or worse in future and invest all his money in one stock or industry.

Diversification shields the investments against risks, as some investment rises in value and while others fall, it levels out the volatility of overall return from a portfolio by offsetting the downside with others going upside. However, everyone knows about the need of diversification for their portfolio but very few really understand the true statistical data underlying it. As a result, majority of portfolios are exposed to risks by most investors. Before an investor goes ahead diversifying his portfolio, he must understand what following risks are.

Systematic Risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group, or component of a system. On the other hand, unsystematic risk is when a single company causes considerable movement either up or down. This is the risk which most of the investors want to eliminate from their portfolio. The last one is Time risk, according to which the longer one holds an investment, the less the overall risk. It means the risk in a risky stock gets lower the longer it is held. A proper diversification is a core principle of an efficient investment particularly when individual stocks are traded. If an investor comprehends the basics of investing correctly and allows his investments time to grow, one can achieve successful investments.

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