Diversification Definition

Diversification is an investing strategy for managing risk. When a business wants to diversify its assets, it invests in a wide range of companies, industries, and types of assets. This might mean investing in stocks, bonds, mutual funds, and even real estate. Read on to understand what the meaning of diversification could be for a small business.

What is diversification?

When a portfolio meets the diversification definition, it contains a mix of asset types. This is to limit the investor’s exposure to any single type of risk. A diversified portfolio, in theory, should not only protect an investor as an individual or a business owner from investment risk, but provide them with higher long-term results than holding any one type of asset. 

One major benefit to a diversified portfolio is that those holdings can be diversified across asset classes, as well as industries and markets. The theory behind this type of diversification is that positive performance in one area of a portfolio can counterbalance losses in another area.

Diversification Examples

An investor can create a diversified portfolio using stocks, bonds, and mutual funds. One diversification example that some individuals use is called the 3-fund portfolio. Using just three index funds, many investors have successfully created and maintained a low-risk, diversified portfolio.

However, an investor chooses to construct and diversify their portfolio, diversification is an important growth and risk-management strategy. 

Diversification Benefits

Diversifying a portfolio has a lot of benefits. Some of the most important ones include:

• Reducing portfolio risk for investors
• Reducing market risk for investors
• Smoothing gains and losses
• Offering higher long-term gains than investing in single asset classes alone
• Hedging against volatility

These benefits make diversifying a portfolio attractive not only because of the risk reduction aspects but also because of the potential economic gains. Whether someone manages their own money or has an outside money manager working with them, it’s prudent to consider and discuss diversification strategies.

Diversification Disadvantages

Despite its many benefits, there are some potential downsides to diversifying assets. If a portfolio has many diverse assets, it can become expensive and time-consuming to manage them. Buying, selling, and keeping track of reporting different assets in different markets on different exchanges involves more transaction fees and, often, higher broker commissions. And as Sir Isaac Newton is reported to have once said, “What goes up, must come down.” Meaning, that while diversification can increase the potential return on investment, the spread-out strategies often significantly temper the potential reward as well. 

Diversification: Summary

• Diversification is a strategy that mixes a variety of investments in a portfolio.
• Portfolio holdings can be diversified across asset classes and markets.
• Diversification limits risk but can also temper performance.

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How ZenBusiness Can Help

ZenBusiness can help any entrepreneur get their business going, so they can focus on building their business and diversifying their portfolio. ZenBusiness’s Corporate and LLC Formation Services can help anyone set up their new company. What’s more, their complete suite of business services, from Worry-Free Compliance Service to ZenBusiness Money Pro, can help a new company stay on track. And once it’s up and running, the Accounting Basics for Your Small Business guide can help entrepreneurs gain the confidence to keep track of their money and keep it growing.