The importance of diversification
When it comes to creating an investment portfolio to help you maintain your quality of life during retirement, most experts agree that diversification is a good option for achieving desired returns while managing risk. But what does it mean to diversify your investments? Let's break it down …
Basically, "diversification" means balancing the investments you have in your portfolio among different categories, classes and industries so that – in a given economic situation – they don't all go up or go down together.
The term "correlation" is used to describe how one type of investment behaves in relation to another. If two types of investments behave similarly, they are said to be "positively correlated." If they behave differently, they're "negatively correlated." Here's an illustration:
Imagine two companies, one called Suntan Lotion, Inc. and the other, Sunglasses, Inc. Sales at both of these companies would go up when it's sunny and down when it rains. So, the value of both of these investments rises and falls in the same cycle. They're positively correlated.
Remember that diversification does not ensure a profit or protect against a market loss.
But let's introduce another company called Umbrellas, Inc. Unlike the other two companies, this company's sales go up when it rains and down when the sun shines. They're negatively correlated.
This illustrates the principle of diversification. By substituting Umbrellas, Inc. for Sunglasses, Inc., we show how negative correlation helps diversify a portfolio. Now our portfolio contains companies representing different types of investments with different behavior. The value of one could rise when the value of the other falls.
So, investing in both may result in a portfolio with steadier performance. And on a more complex level, that is the approach that investment professionals suggest you apply to your own investments.
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