There are two important reasons to diversify your investment portfolio:
To take maximum advantage of market conditions
To protect yourself against downturns
Taking advantage of different markets
Each of the traditional
asset
classes
— stocks, bonds, and cash — tends to
produce its strongest returns under different market conditions
than the other asset classes do.
For
example, stocks often shine when corporate earnings are strong
and financial markets are expanding. Yet this same environment
frequently has the opposite effect on bonds, so that they provide
lower than average
returns.
On
the other hand, bond returns often rise in a period when stock
values drop. That may happen when
interest
rates
go up or when corporate earnings don't meet investor
expectations. If you have some money in both stocks and bonds,
you'll be in a position to benefit from owning the one that's
up, while limiting your losses on the one that's down.
Protection against downturns
If your investments are narrowly focused
— for example, if you own stock in just one company or stock
in three companies in the same industry or area of the economy
— the value of your portfolio can drop sharply if that company
or industry provides disappointing returns. But if you own stocks
of different-sized companies in different parts of the economy,
even if some investments go down in value, others may remain stable
or go up. In any case, different types of stocks are not as likely
to lose value at the same rate or at the same time.
