Sometimes economic policies, business environment and changing consumer preference might favor one sector to the detriment of another. Even within the favored sector, it’s also possible that the managers in any of the businesses in that sector could make a wrong business decision.
Hence, the need to protect yourself by spreading your investments.
Quite simply, diversification requires that you split your investment portfolio into different asset classes. Even within an asset class like equities, you need further diversification among the various sectors and securities within a sector.
What diversification does is it gives your portfolio some stability but only if you split your investments into asset classes that are not correlated – do not have similar price movements. For instance, a fall in the price of crude oil would be followed by a drop in the share price of companies that sell electric cars while those that produce gas powered will see their stock price move higher. If the government were to raise interest rates, it could negatively impact the equity market while the debt market gets a boost.
It also protects from human bias of believing past performance will be repeated in the future. A good position, might leave you feeling like a genius and we in the quest for a bigger payoff, you might be tempted to double down on your winners.
In the end, a well-diversified portfolio, will have some assets that are doing well and some that are not doing so well or even doing poorly. But in the end, you have a stable portfolio and more consistent investment returns.
At the core of diversification is the wisdom not to put all your eggs in one basket, however, after a certain point this benefit diminishes. Studies have shown that the benefit of diversification starts to diminish when a portfolio holds more than 15 individual stocks.