So far, we have discussed the concepts surrounding building a financial pyramid, risk vs reward, and understanding your own risk tolerance. These ideas give you a clear path in which to create your ideal allocation of investments. Here is where diversification comes in. Whatever your risk tolerance level or what your goals are you must use diversification as part of your investment strategy. So what exactly is diversification?
Diversification is allocating your assets across the major asset classes (stocks, bonds and cash) in order to make your best possible return within your risk spectrum. Each class then has a deeper diversification capability – you may take advantage of different investment styles such as growth or value stocks and even further by sector such as technology or healthcare. Diversification is a balancing act that encompasses your risk tolerance.
All investments have a certain amount of risk and by utilizing diversification strategies your goal is to mitigate that risk. As you diversify you should consider the fund's investment objectives, risks, charges, and expenses. Although diversifying cannot guarantee a profit or make certain to protect you from loss it can allow you to pursue your goals at a risk level you find comfortable. Once you find a comfortable mix of assets and styles it is important to monitor your investments, possibly needing to rebalance to maintain your desired allocation as time goes on.