DIVERSIFICATION IN STOCKS

Diversification offers you a way to reduce risk. It is possible to have a diversified portfolio of just stocks; just bonds; stocks and bonds; or stocks, bonds, and cash; etc. The portfolio design is very important to effectively minimizing risk.

It is important to consider how to reduce unsystematic risk if you want to create an effectively diversified portfolio of stocks. For example: It is possible that if you invest in the book publishing industry, that all the book binders in the industry will make a pact to go on strike. The effects of such an event could lead the prices of all publishing stocks in that industry to plummet. Your holdings in publishing companies would be left at a deflated level.

However, if you also had holdings in other industries such as oil, consumer durables, and electronics, it is unlikely that the unsystematic risks in the publishing industry will adversely affect your other holdings. What is more, unfortunate circumstances in the book publishing business may result in a boom in other industries. The delays in the traditional print publishing business mentioned previously could cause people to publish materials in electronic form. If you held stock in an electronic publishing company, your stock might even benefit from the troubles that are slowing the growth of your holdings in the book publishing industry.

Unsystematic risks can be avoided by diversifying among different industries rather than just investing in the same one. They may also be effectively mitigated by diversifying across different asset classes such as stocks, bonds, mutual funds, real estate holdings, etc. Let us take a look how this is done.