Why Diversification in Investments is Important

Spreading your assets over a variety of different investments is perhaps the single most important rule you can follow, financial experts say.

The reason: If you diversify your portfolio, your investment performance should fluctuate less because losses from some investments are offset by gains in others. Therefore, you should have less risk than if you put all your money in one type of investment, such as stocks and bonds.
Diversification also makes sense because no single asset class performs best in all economic environments. For example, in a diversified portfolio, a decline in U.S. bonds may be offset by good performance from international stocks.

Diversify with three basic tools. The three basic tools you need to diversify are cash, bonds, and stocks. Cash includes money market securities, such as Treasury Bills and short-term certificates of deposit. Bonds are IOUs issued by corporations, governments and federal agencies. Compared with money market investments, bonds have longer maturities and provide more income. Stocks represent more risk than other types of financial assets. Over longer holding periods, they have usually provided the highest returns and the greatest margin over inflation.

How much emphasis you place on stocks for growth, bonds for income, and money market securities for safety and liquidity will depend in part on your tolerance for risk and your time horizons for achieving your financial goals. Most experienced investors pursue a diversified strategy using all three types of assets.

Over the long term, a diversified mix of assets can outperform a very conservative investment in money market securities or Treasury bills and at the same time avoid the higher risk of an all-stock portfolio.

To earn these high returns, however, a diversified investor must be willing to tolerate more volatility in annual returns than an investor in Treasury bills, but considerably less than someone who invests only in stocks.

Keep in mind that a diversified investment strategy does not eliminate risk or guarantee success. It does offer a way for you to earn potentially higher returns over time without exposing you to the greater risk of more aggressive strategies

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