"Don't put all your eggs in one basket." That is the whole idea. If your savings are all in one company and that company has a bad year, you feel all of it. If they are spread across many, one bad year hurts less.
Ways to spread
- Across companies: many businesses instead of one.
- Across sectors: for example, not only banks, but also consumer goods, technology, energy and so on.
- Across asset types: shares, bonds, bank deposits, gold. These often react differently to the same news.
- Across time: investing a little regularly instead of everything on one day, as in a SIP.
A made-up example
Two people each hold ₹1 lakh. Asha holds only shares of Sunrise Biscuits Ltd. Ravi holds small parts of twenty different companies. If Sunrise Biscuits has a scandal and its price halves, Asha loses half her money. Ravi loses only a small slice. The reverse is also true: if Sunrise Biscuits soars, Asha gains more. Diversification smooths the ride in both directions.
Mutual funds and diversification
A mutual fund already holds many securities, which is one reason people use them. Read what a mutual fund is to see how that works. But funds can also be concentrated, for example a fund that holds only one sector.
What it cannot do
- It cannot remove market risk. In a broad fall, most shares drop together.
- It cannot guarantee profit or protect against loss.
- Owning many similar things is not true diversification. Ten banks react to many of the same events.
- Too much spreading makes it hard to follow what you own.
This page explains an idea. It does not tell anyone how to split their money.