You have probably heard the saying, “don’t put all your eggs in one basket.” When your parents tell you this, they are trying to tell you not to risk everything on one thing. But how is this relevant to investing?
Not putting all your eggs in one basket means that you can spread out your risk. By holding different types of companies in your portfolio, you may be able to reduce your risk, which is called diversification in investing. For example, if you invested all your money into one company, and that company's value falls (or they fail completely), then you can lose a significant amount of your investment. In contrast, if you invested your money into multiple companies, it won't affect your portfolio as much if one of them fails.
Reducing your risk may help decrease your chances of losing money on your investments. However, a lower level of risk may also reduce your potential return.
Diversification may be useful when the stock market is volatile. Volatility means that stock prices are fluctuating up and down rapidly. More volatility could cause an investor to lose more money if they were not diversified.
There is no one right way to approach diversification. Find a level of diversification that you are comfortable with and stick to it.
Now that we have our eggs in a row, let’s check out diversifying by market cap.