The Advantages of Diversification

When you invest in a mix of different types of investments, you are diversifying. Diversification means lowering your risk by spreading money across and within different asset classes, such as stocks, bonds and cash. It's one of the best ways to weather market ups and downs and maintain the potential for growth.

Why diversification works

There's no such thing as a sure thing. Different investments perform in different ways at different times, so it helps to own a variety.

You don't want your portfolio to be dependent on the performance of any one investment. For example, if you own only one stock and it falls 20 percent, the value of your investments is down 20 percent. By adding in even one more stock that rises (or even doesn't go down as much) when the other one falls, it should improve your portfolio.

Ways to diversify

In Stocks, Bonds and Cash, we learned about asset classes and certain characteristics of those asset classes. Now, you can put that knowledge to work for you.

To begin with, you can diversify your portfolio in three ways:

• Across asset classes with a long-term asset allocation plan that combines different categories of major types of investments like stocks, bonds, commodities (like gold or other precious metals), and cash.
   
• Within asset classes so you're not too concentrated in any one market sector (e.g., technology or health care), company, company size (e.g. large cap, mid cap, small cap), or country.
   
• By mixing investing styles through a combination of both value and growth stocks. This will help reduce the risks associated with investing strategies that perform better or worse in certain markets.

How much to diversify

While there are no hard and fast rules about how much to diversify, holding two or three stocks is probably not going to give you enough protection against market ups and downs. Generally speaking, the wider the number of holdings, the greater the diversification benefits. Consider the following guidelines:

• For a well-diversified stock portfolio, start with a globally diversified portfolio across sectors, industries, and countries.
   
• For most investors a bond portfolio composed primarily of high-quality, investment-grade government and corporate bonds is a good place to start. High-yield junk bonds or foreign bonds may be additions to consider when constructing globally diversified portfolio of bonds depending on your risk tolerance.

A stock or bond mutual fund or Exchange traded fund (ETF) can offer broad diversification in a single investment with a small amount of money.