You've probably heard the phrase, "Don't put all your eggs in one basket." An investment strategy that relies on the income and returns of one stock does just that. If that stock experiences huge gains, you win. You lose if that stock experiences a loss in value. A diversified portfolio occurs when you hold many different types of investments. Some of those investments may include U.S. stocks, international stocks, bonds, or mutual funds.
Portfolio diversification tends to reduce your long-term risk. Anytime you hold an investment, you risk losing its value. For example, if you purchase a share of stock for $50 and end up selling it for $35, you incur a loss. Now imagine that you own two shares of stock. You purchase one stock for $50 and end up selling it for $35. The second stock costs $10 and you sell it for $25. In this example, you eliminate your loss through diversification. Most diversified portfolios do not achieve complete elimination of loss -- only reductions in its potential.
A diversified portfolio could result in higher returns. Between January 1, 2001 and November 30th, 2011, the Standard and Poor's 500 Fund Index returned a 1.4 percent gain. Investors with diversified portfolios returned an average 5.4 percent gain during the same time period, according to "USA Today." A larger percentage of bonds were in the diversified portfolios. Higher returns from diversification tend to be seen with longer periods of time. Diversification does not always increase returns in the short term, however. If the overall health of the investment market is poor, diversification may still result in a negative return.
An advantage of diversification is that you can adjust your investment mix. A more risky, growth-oriented strategy makes more sense when you're young. You have more time to tolerate ups and downs in the market. A growth-oriented diversification strategy for 20- to 30-year-olds might consist of 90 percent stocks and 10 percent bonds, according to USA Today. If your diversification strategy is more advanced, you might invest heavily in the stocks of small and emerging U.S.-based companies.
Behavioral portfolio theory states that investments either protect from loss or provide high-growth potential. According to the theory, your portfolio represents a pyramid when you diversify. A diversified portfolio has a higher percentage of low-risk, income and value investments. At the top of the portfolio pyramid is a lower percentage of "blend" and growth funds. "Blend" funds are a combination of high-risk and risk-averse investments. Portfolio diversification allows you to achieve more than one financial goal. The income and value investments can provide you with stability and regular payments. Blend and growth funds can help you increase your wealth. Of course, any of these can incur risk; positive returns are never guaranteed.
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