Hedging-Strategies.net

Diversification in finance is a risk management technique, related to hedging, that mixes a wide variety of investments within a portfolio. It is the spreading out investments to reduce risks. [1]Because the fluctuations of a single security have less impact on a diverse portfolio, diversification minimizes the risk from any one investment. A simple example of diversification is the following: On a particular island the entire economy consists of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio is completely invested in the company that sells umbrellas, it will have strong performance during the rainy season, but poor performance when the weather is sunny. The reverse occurs if the portfolio is only invested in the sunscreen company, the alternative investment: the portfolio will be high performance when the sun is out, but will tank when clouds roll in. To minimize the weather-dependent risk in the example portfolio, the investment should be split between the companies. With this diversified portfolio, returns are decent no matter the weather, rather than alternating between excellent and terrible. There are three primary strategies used in hedging strategies improving diversification: 1. Spread the portfolio among multiple investment vehicles, such as stocks, mutual funds, bonds, and cash. 2. Vary the risk in the securities. A portfolio can also be diversified into different mutual fund investment strategies, hedging strategies including growth funds, balanced funds, index funds, small cap, and large cap funds. When a portfolio includes investments with varied risk levels, large losses in one area are offset by other areas. 3. Vary your hedging strategies securities by industry, or by geography. This will minimize hedging strategies the impact of industry- or location-specific risks. The example portfolio above was diversified by investing in both umbrellas and sunscreen. Another practical application of this kind of diversification is mixing investments between domestic and international funds. By choosing funds in many countries, events within any one country's economy have less effect on the overall portfolio. Diversification reduces the risk of a portfolio, and consequently it can reduce the returns. However, since diversification hedging strategies reduces the risk of an entire portfolio being diminished by a single investment's loss, it is referred to as "the only free lunch in finance."[2] Statistical analysis shows that there may be some validity to this claim.[3]