Diversification involves pooling investment assets with the aim of limiting risk.
In this case, risk refers to volatility or fluctuations in the value of individual investment assets. The idea is that two investment assets are less likely to suffer dramatic fluctuations in value at the same time.
Diversification may involve investing in different types of investment vehicles, sectors, or industries. Thus, for example, diversification can help limit the loss associated with a widespread stock sale triggered by a Wall Street scandal if the investor also owns real estate, commodities, or bonds or if the investor’s stock investments are in industries that are not a part of the Wall Street sell off.
Financial advisers generally recommend that clients diversify their investment holdings, with the aim of making smaller gains over time. This is often referred to as having a long-term investment philosophy.
Other financial advisers take the position that diversification unnecessarily limits upside risk, or the ability to make higher returns. These speculative financial advisers prefer to invest in very few investment holdings or sectors, with the hope that the investment or sector will increase. This is more consistent with a short-term investment philosophy.
A number of academics and finance professionals have analyzed diversification in light of higher risk being associated with higher returns, by asking whether an investor can achieve higher returns with less risk.
Modern portfolio theory or MPT proposes that investors will examine the expected risk and return of all available investments and invest in a group of investments that has the lowest expected risk for the highest potential return. More precisely, MPT proposes that investors can add a third variable to the risk-return variables, the risk-free asset, to determine the optimal investment asset portfolio (The risk-free asset is usually the US Treasury Bond, which is backed by the full faith and credit of the US government).
Academics and financial professionals often debate whether MPT is a valid theory, which leads to further debate as to whether investors or the markets act rationally.
As a practical matter, research has shown that a diversified portfolio will generally out pace un-diversified portfolios over a longer period of time. Absent insider information or good luck, investors should hold a diversified portfolio of investment assets.