The Importance of Diversification
A Tool for Managing Risk
Diversification is an investment strategy that is employed in an attempt to offset market volatility and reduce portfolio risk. By diversifying your portfolio, you may reduce the chances of having all your assets in one investment that performs poorly, while potentially increasing the chances of having at least some of your assets in an investment that does well. Since mutual funds typically invest in dozens of securities in a variety of companies, industries and geographical areas, they have the potential to provide investors with built-in diversification.
As an example, consider the illustration below. If you were to invest all of your assets in a single company—Company A, a 25% drop in Company A’s stock would result in a loss of 25% of your total investment. However, if you were to diversify your holdings by investing in a mutual fund that included the stock of Company A as well as other companies, the same 25% drop in Company A’s stock may have only a minor impact on your total investment. In fact in this example, by investing in a mutual fund composed of 42 different stocks in equal percentages, a 25% drop in one stock would impact your overall portfolio by only one half of one percent.
Diversification can be attained in several ways:
Diversification by Asset Class
- Stocks — represent partial ownership of the issuing company. If the company does well and the price of its stock goes up, the shareholders’ investments increase in value.
- Bonds — represent the debt of corporations, the US Treasury and other government entities, and other debt issuers. Bonds typically pay a fixed rate of interest income for a set period of time. Bond prices have an inverse relationship with interest rates so that bond values will typically decline as interest rates rise.
- Cash — includes money market instruments that pay either a fixed or variable rate of income for a short
duration, and return the principal to the investor when the time period has passed.
Diversification by Investment Type
Each of these asset classes is composed of different investment types that can provide additional levels of
diversification.
Stocks
May be further differentiated according to:
- Geographic Regions
- Sector/Size
- Type – i.e., value- or growth-oriented
Bonds/Debt Securities
Bonds are classified according to size, issuer, credit quality, interest rate sensitivity and duration.
Cash
Cash includes money market instruments, certificates of deposit, T-bills and commercial paper.
Diversification by Fund and Management Style
Many types of mutual funds are available, and investors may wish to hold a combination of funds in order to gain exposure to each asset class. In addition, by investing in more than one mutual fund, investors can ensure that securities selection responsibilities are divided among a number of managers, each of whom may specialize in a particular investment discipline.
Diversification does not assure a profit or protect against market loss.
Investments in foreign markets may involve risks such as foreign currency exchange rate fluctuations, political and economic conditions and foreign taxation.
An investment in a money market fund is neither insured nor guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Yields will fluctuate, and although the fund seeks to preserve the value of your investment as $1.00 per share, it is possible to lose money by investing in the fund.
Before investing in a mutual fund, consider its investment objectives, risks, charges and expenses carefully. The
prospectus, which contains this and other information about the mutual fund, can be obtained by contacting
Legend Equities Corporation. Please read the prospectus carefully before you invest or send money.