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The Importance of Diversification in Building an Investment Portfolio

Diversification is the single most important element of building an investment portfolio. Regardless of whether you invest in stocks, bonds, mutual funds, pieces of art, or llama farms, having your money spread around to multiple investments is a necessary strategy.

What does it mean to diversify your investments? It simply means that you put your money in a wide range of different investments. Whatever it may be that you are investing in, be sure to spread your money around. It is important to do this in order to spread out your risk. If you have all your money in a single investment and that investment goes broke, you are in big trouble. If you have your money spread you in multiple investments and one goes bad, you still have all the others to "protect" you.

For example, if you are investing in stocks, being properly diversified means that you will have multiple stocks. You should be buying stocks in different companies, as well as different types of companies. Don't buy just technology stocks, or oil, or pharmaceuticals. Why not? Because if something goes bad with a single industry, you won't loose as much. This is the basis of what diversification is - mitigating risk.

The same idea holds true for other types of investments. If you are buying mutual funds, you are already somewhat diversified, as each fund holds dozens of different stocks. However, you can extend this diversification further by investing in multiple types of mutual funds. Some may buy tech stocks, others may buy bonds or stocks of large companies. With a few good mutual fund picks, you can achieve a wide range of diversification much more easily than when you pick the stocks individually.

The higher the risk of your investment, the more important proper diversification becomes. Say you are talked in to buying a llama farm. I'm not sure how anyone makes money with a llama farm, but people own them for some reason. If you only have one small farm with a few llamas, you are at tremendous risk if something should go wrong. Llamas get sick, weather goes bad, fences fall over and the llamas escape - you get the idea. But if you have lots of llamas on many different farms, the odds that you will loose all of them in a single disaster are much lower. Think of it as llama redundancy.

Of course, proper diversification would mean that you should have multiple types of investments. It's a good idea to own a little of many things, including stocks, bonds, mutual funds and llama farms. Depending on your tolerance for risk, you can choose safer or riskier investments in each category. But even if you are taking a riskier route, it's still a good idea to spread the risk - some stocks, a few mutual funds and don't forget the llama farms!

Learn more about this author, Erich Rosenberger M.D..
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