Diversification

Diversification is a familiar term to most investors. In the most general sense, it can be summed up
with this phrase: "Don’t put all of your eggs in one basket." While that sentiment certainly captures
the essence of the issue, it provides little guidance on the practical implications of the
role diversification plays in an investor's portfolio and offers no insight into how a diversified
portfolio is actually created. In this article, we'll provide an overview of diversification and give you
some insight into how you can make it work to your advantage. 

What is Diversification? 
Taking a closer look at the concept of diversification, the idea is to create a portfolio that includes
multiple investments in order to reduce risk. Consider, for example, an investment that consists of
only the stock issued by a single company. If that company's stock suffers a serious downturn, your
portfolio will sustain the full brunt of the decline. By splitting your investment between the stocks of
two different companies, you reduce the potential risk to your portfolio. (For more insight, read
Determining Risk And The Risk Pyramid.)

Another way to reduce the risk in your portfolio is to include bonds and cash. Because cash is
generally used as a short-term reserve, most investors develop an asset allocation strategy for their
portfolios based primarily on the use of stocks and bonds. It is never a bad idea to keep a portion of
your invested assets in cash, or short-term money-market securities. Cash can be used in case of an
emergency, and short-term money-market securities can be liquidated instantly in case an
investment opportunity arises, or in the event your usual cash requirements spike and you need to
sell investments to make payments. Also keep in mind that asset allocation and diversification are
closely linked concepts; a diversified portfolio is created through the process of asset allocation.
When creating a portfolio that contains both stocks and bonds, aggressive investors may lean toward
a mix of 80% stocks and 20% bonds while conservative investors may prefer a 20% stocks to 80%
bonds mix.

Regardless of whether you are aggressive or conservative, the use of asset allocation to reduce risk
through the selection of a balance of stocks and bonds for your portfolio is a more detailed
description of how a diversified portfolio is created than the simplistic eggs in one basket concept.
With this in mind, you will notice that mutual fund portfolios composed of a mix that includes both
stocks and bonds are referred to as "balanced" portfolios. The specific balance of stocks and bonds in
a given portfolio is designed to create a specific risk-reward ratio that offers the opportunity to
achieve a certain rate of return on your investment in exchange for your willingness to accept a
certain amount of risk. In general, the more risk you are willing to take, the greater the potential
return on your investment. (To learn more, check out Achieving Optimal Asset Allocation and Five
Things To Know About Asset Allocation.)

What are My Options?

If you are a person of limited means or you simply prefer uncomplicated investment scenarios, you
could choose a single balanced mutual fund and invest all of your assets in the fund. For most
investors, this strategy is far too simplistic. While a given mix of investments may be appropriate for
a child's college education fund, that mix may not be a good match for long-term goals, such as
retirement or estate planning. Likewise, investors with large sums of money often require strategies
designed to address more complex needs, such as minimizing capital gains taxes or generating
reliable income streams. Furthermore, while investing in a single mutual fund provides diversification
among the basic asset classes of stocks, bonds and cash (funds often hold a small amount of cash
from which to take their fees), the opportunities for diversification go far beyond these basic
categories. (For more detail, read Advantages Of Mutual Funds and Disadvantages Of Mutual Funds.)

With stocks, investors can choose a specific style, such as focusing on large caps, mid caps or small
caps. In each of these areas are stocks categorized as growth or value. Additional choices include
domestic stocks and foreign stocks. Foreign stocks also offer sub-categorizations that include both
developed and emerging markets. Both foreign and domestic stocks are also available in specific
sectors, such as biotechnology and health care.

In addition to the variety of equity investment choices, bonds also offer opportunities for
diversification. Investors can choose long-term or short-term issues. They can also select high-yield or
municipal bonds. Once again, risk tolerance and personal investment requirements will largely
dictate investment selection.

While stocks and bonds represent the traditional tools for portfolio construction, a host of alternative
investments provide the opportunity for further diversification. Real estate investment trusts, hedge
funds, art and other investments provide the opportunity to invest in vehicles that do not necessarily
move in tandem with the traditional financial markets. These investments offer yet another method
of portfolio diversification. (To read more, see Diversification Beyond Equities and Asset Allocation
Within Fixed Income.)

Concerns
With so many investments to choose from, it may seem that diversification is an easy objective to
achieve, but that sentiment is only partially true. The need to make wise choices still applies to a
diversified portfolio. Furthermore, it is possible to over-diversify your portfolio, which will negatively
impact your returns. Many financial experts agree that 20 stocks is the optimal number for a
diversified equity portfolio. With that in mind, buying 50 individual stocks or four large-cap mutual
funds may do more harm than good. Having too many investments in your portfolio doesn't allow
any one of them to have much impact, and an over-diversified portfolio (sometimes called
"diworsification") often begins to behave like an index fund. In the case of holding a few large-cap
mutual funds, multiple funds bring the additional risks of overlapping holdings as well as a variety of
expenses, such as low balance fees and varying expense ratios, which could have been avoided
through more careful fund selection. (For more details, see The Dangers Of Over-Diversification.)

Tools
Investors have many tools to choose from when creating a portfolio. For those lacking time, money
or interest in investing, mutual funds provide a convenient option; there is a fund for nearly every
taste, style and asset allocation strategy. For those with an interest in individual securities, there are
stocks and bonds to meet every need. Sometimes investors may even add rare coins, art, real estate
and other off-the-beaten-track investments to their portfolios.

Conclusion
Regardless of your means or method, keep in mind that there is no generic diversification model that
will meet the needs of every investor. Your personal time horizon, risk tolerance, investment goals,
financial means and level of investment experience will play a large role in dictating your investment
mix. Start by figuring out the mix of stocks, bonds and cash that will be required to meet your needs.
From there, determine exactly which investments to use in completing the mix, substituting
traditional assets for alternatives as needed. If you are too overwhelmed by the choices or simply
prefer to delegate, there are plenty of financial services professionals available to assist you. (See
Choosing An Advisor: Wall Street Vs Main Street and Shopping For A Financial Advisor.)