What Is Diversification, and Why Is It Important?

A full body description of what diversification is, how the economy and market moves, and how to minimize your exposure to one sector, while benefiting from each sector.

By Simon Mugo
Edited by Taj Schlebusch

Published April 16, 2021.

Diversification is a rule that requires investors to split the funds they have to invest among several investments instead of putting all their money into one asset. For stock market investors, diversification means buying stocks in different sectors to spread your risk.

Diversification is important because various sectors of the economy move differently. For example, while tech stocks might be booming, industrials and utilities might be languishing at the bottom of the market. The opposite is also true; investors tend to flock to value stocks when growth stocks are falling.

Investors who are over-exposed to one sector of the economy may see all their portfolio gains eroded when the sector sells off, which always happens. The economy and the market move in boom and bust cycles, more commonly known as bull and bear markets.

On a larger scale, diversification means splitting your assets between the main asset classes, including real estate, stocks, commodities, and bonds. By having a diversified investment portfolio, investors can benefit from gains in different economic sectors while minimizing their losses when one sector falls.

You should always try to diversify your investments regardless of the amount you are investing. The bigger your investments, the more important diversification becomes.