Debt Dictionary


Investment Dictionary -> Diversification

Diversification represents a technique for the identification and assessment of potential risks and combines a diverse array of investments in a portfolio. The justification is that fluctuations in the value of single security will have smaller negative impact as a part of a diversified portfolio. In this way, diversification reduces the overall risk of the investments.

There are three major strategies to enhance the quality of diversification. Firstly, the portfolio may comprise of various investment instruments such as bonds, cash, and stocks, among others. Secondly, one may employ various mutual fund strategies such as investment in balanced and index funds. This approach entails the creation of portfolio which comprises of instruments with varying levels of risk. Losses incurred by investments in some areas will be compensated by profits gained in other areas. Thirdly, one may diversify the industry type and geographic locations of the securities. This approach aims to lessen the impact of risks associated with the possible decline of particular industries. Moreover, weather conditions such as regional floods, storms, and floods may cause extensive damages on certain locally based industries. Furthermore, it is best to simultaneously invest in domestic and international securities. Even if one country is experiencing economic decline, the overall portfolio will include other countries of varying degrees of economic growth.

Asset diversification comprises of horizontal and vertical diversification. The first type occurs when the investor holds securities in various companies which engage in a certain activity at the same stage of the production process. Vertical diversification refers to investment in companies which are engaged in different phases of production: from raw materials to finished products. In general, horizontal diversification narrows the investment to companies within a single sector. Vertical diversification increases the scope of investment to the purchases of stocks in different branches. Moreover, broader diversification may entail the purchase of both, stocks and bonds within diverse array of sectors.

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