What Does Diversification Mean in Finance?

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Creating an investment portfolio is important to ensure you can reach your financial goals both short term and long term. If you're new to investing, you may be lost as to how you should invest. One of the most important things is that you have a diversified portfolio. Diversification in finance is the idea of spreading your investments across multiple sectors and asset classes. For example, the stock market is a popular investment choice for novices and experts alike, but you wouldn't want to invest all your money in the same company. If that company were to go under, you'd lose all your money. The volatility of the stock market in general means you probably shouldn't invest all your money even across multiple stocks. You need to diversify by investing in different asset classes. Here are just a few that can help you build a stronger portfolio.

Mutual Funds

These are created when multiple investors pool money and invest it in different securities such as stocks, bonds, commodities, and more. The mutual fund is overseen by a money manager who follows investment objectives and attempts to generate income for the investors. The shareholders take on proportional risks and rewards based on the amount they invested.

There are several types of mutual funds with equity (stock) funds being the most common. These can be extremely profitable but tend to assume a higher risk than other types. A common risk-free option is a money market fund. With these mutual funds, investments are made in debt securities such as debts guaranteed by banks or the U.S. Treasury. Money market funds are safe and mature quickly, often within a year. The downside is that they don't tend to provide high returns.

Certificates of Deposit

CDs are safe options for investors with low risk tolerance. All banks offer these, and customers simply have to agree to make a deposit and not touch the money for a specified period of time. During this time, the money will accrue interest, and the depositor will profit once the CD matures. Considering interest rates are low now, CDs won't be as profitable as other options. Still, they can be good for young investors or those who need just a bit more money to reach a short-term goal.

Commodities

These are raw materials and basic goods that are essentially the same as other goods of the same type. For example, gold is a commonly sought after commodity, and gold from one source is the same as the gold from another. Commodities can also be things like crops, livestock, oil, and any other goods frequently used in the creation of other products. Commodities are considered a great option for diversification since they can help protect you against inflation.

Real Estate

The idea of investing in real estate may seem intimidating to a new investor, but it really doesn't have to be that complicated or expensive. You have options to invest in properties without having to actually own or manage them. Common examples are real estate investment trusts (REIT). A REIT is a company that owns commercial real estate such as apartments, hotels, stores, malls, and storage facilities. REITs have to follow several rules, including returning at least 90% of their taxable income as shareholder dividends each year. This high-profit potential makes REITs an extremely attractive option for investors.

REITs can either own the property, or they can control debt securities backed by the property. Mortgage REITs are generally considered to be a greater risk, but they tend to offer higher dividends. REITs can be bought and traded essentially like stocks, so it isn't difficult to get started.

These are just a few examples of diversification. The more asset allocation you do, the higher your chances of earning consistent profits.

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