“Don’t put all of your eggs in one basket.” In the financial world,the advice points to diversification. So what is diversification actually? Diversification is one of the important techniques for reducing risk in investment. We must need to understand that diversification cannot destroy risk completely. It can only helps in reducing risk but not totally destroy it.
In investing, there will be a risk whether it is diversified or not. In general, there are two types of risk in doing the investment. The first one is diversifiable risk. It is directly related to each company and can be reduced by diversifying . For each asset, they will have different business and financial risk. It means that if you invest in the assets, both of them will not affected the same. While the second one is undiversifiable risk or also known as systematic risk which is every company and industry will eventually face it. For instance inflation rates, political climate, interest rates and war.
When comes to investing, the company are recommended to invest in broad various large and small firms in different industries as well as in foreign companies. When the company is invest everythings in one industry,it shows a really weak strategy. Just imagine if the industry was affected badly in the economy and the company had invested everythings in that particular industry then it will be the end for them. So, to avoid that kind of situation and to protect you wealth, the company must diversify smartly. A company must invest in a wide variety of industries,companies and assets class.
Diversification may mean earning more slowly. The higher the risk,the greater the rewards. However, if the company just choose one industry,it will be a huge hit for the company when the industry gains profit but it also means the company will be in dangerous state when the industry falls down. So when a company using diversification, it will be safe. When one of the industry gains profit while the other drops, the portfolio of the company will be stable. This shows that diversification can reduce risk in investment. But remember, through diversification a company cannot maximise the profit.
Next, a well diversified portfolio fully depends on the risk of individual securities that included in the portfolio is measured by beta. It is the measure of risk.