As they say, don’t put all your eggs in one basket. Diversification is an important part of portfolio risk management strategy. The goal of diversification is to reduce risk and maximize returns. By allocating the funds across different sectors, industries, companies, or other investment vehicles, one can successfully diversify their portfolio.
Furthermore, A well-diversified portfolio limits exposure to any single asset and contains a mix of distinct investment vehicles. For example, many invest in stocks, real estate, gold, cash, etc. If the value of investment decreases, other investments may increase in value and make up for the loss.
The rationale behind the diversification strategy is that, on average, it will yield higher long-term returns and lower risk compared to holding any individual stock or any other security. So, you can see that diversification reduces risk by investing in vehicles that have different instruments, categories, and sectors. Plus, diversification could mitigate unsystematic risk while systematic risks such as Shariah risk and market risk.
Let say you have a portfolio of technology stocks. The share price will decelerate in line with any bad news such as an indefinite pilot strike. Subsequently, your portfolio will experience a noticeable drop in value.
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