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Investors and financial professionals well acknowledge that investments with high returns are accompanied by high risks. Minimizing losses while maximizing returns is often challenging and requires well-developed diversification strategy.
The primary advantage of diversification is risk reduction, the second benefit is the return maximization and third, it allows portfolio re-diversification once financial goals change over time.
Risk limitation is a key advantage of diversification which allows to reduce the overall risk in a portfolio. This is because a diversified portfolio is not constrained to a single security and hereby is somewhat protected from the market fluctuations. In other words, diversification reduces an investor's risk extending from an individual investment to several investments. It requires the investor to invest his money in a wide variety of investments that belong to different categories and industries and, what is more important, that have different risk levels and are not correlated. In this way investors can feel more secure and be more confident that their portfolio will be insulated from losses in one part of the market.
By reducing the risk, diversification balances the portfolio investment. This means that if the stock portion in the portfolio has a negative performance, the rest, with other types of investments doing well, keep balance in it by compensating for the loss in stock value.
Diversification has an effect on maximizing portfolio returns. This is partly because risk is reduced - by avoiding major losses the portfolio is more likely to make money. As the portfolio is balanced and the money is spread out in various investments, when a single portion of investment is doing well, the investor benefits.
Diversification can also maximize returns by exposing investors to high-return industries. A well diversified portfolio containing securities of high growth industries will have higher profits on average and will be less risky than a safer portfolio without the high-growth industry securities.
Investors should assess and consider portfolio diversification on an annual, semi- annual or quarterly basis. During this assessment the investor should decide whether to pursue the same investment goal or the goal has changed. In case of changes he should re-diversify or re-allocate the portfolio to meet the new goal.
Re-diversification can also take place when a specific part of the portfolio is performing poorly. Investors can re-allocate the portfolio to get out of negatively performing investments and spread out their money in alternative investments which have the potential to perform well.
Though diversification comes with significant advantages, it is always important to note that a diversified portfolio is still exposed to systematic risk which impacts the entire market, and even perfectly diversified portfolios can undergo losses during serious economic crises.