Why Diversification is Necessary while Investing

In stock market one come across several times the word diversification so what exactly diversification mean well it is a method by which one can reduce the risk by allocating investments among various financial instruments, industries and other categories. In simple words it means not putting all your eggs in one basket.

Since investing involves two kind of risk one is called non- diversifiable or unsystematic risk which cannot be reduced. It is due to factors like inflation rates, exchange rates, political instability, war and change in interest rates, since these factors are not in the control of any company and these factors affect almost all companies in the same way and hence they cannot be eliminated or reduced and investors have to live with this risk.

The other kind of risk is called diversifiable risk or systematic risk which is specific to a company, industry, market, economy and hence they can be reduced by investing properly. So having stocks of different industries will reduce the risk considerably in comparison to having stock of only one industry. In the same way one can diversify his investments across various asset classes like commodity, bonds and stocks and various geographical regions.

Though no matter how much one is diversified, risk cannot be eliminated completely and hence one should try to maintain a fine balance between risk and return according to his needs.

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