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What Is Diversification? Individuals

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Another way to reduce the risk in your portfolio is toinclude bonds and cash. Because cash is generally used as a short-term reserve,most investors develop an asset allocation strategy for their portfolios basedprimarily on the use of stocks and bonds. It is never a bad idea to keep aportion 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 marketsecurities can be liquidated instantly in case an investment opportunityarises, or in the event your usual cash requirements spike and you need to sellinvestments to make payments. Also, keep in mind that asset allocation anddiversification are closely linked concepts; a diversified portfolio is createdthrough the process of asset allocation. When creating a portfolio thatcontains both stocks and bonds, aggressive investors may lean towards a mix of80 percent stocks and 20 percent bonds, while conservative investors may prefera 20 percent stocks to 80 percent bonds mix.

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Regardless of whether you are aggressive or conservative, theuse of asset allocation to reduce risk through the selection of a balance ofstocks and bonds for your portfolio is a reliable way to create a diversifiedportfolio. Some mutual funds aim to have a mix of securities that includes bothstocks and bonds to create ready-made "balanced" portfolios. Thespecific balance of stocks and bonds in a given portfolio is designed to createa specific risk-reward ratio that offers the opportunity to achieve a certainrate of return on your investment in exchange for your willingness to accept acertain amount of risk. In general, the more risk you are willing to take, thegreater the potential return on your investment.

What Are My Options?

If you are a person of limited means, or if you simplyprefer uncomplicated investment scenarios, you could choose a single balancedmutual fund and invest all of your assets in the fund. For most investors, thisstrategy is far too simplistic. While a given mix of investments may beappropriate for a child's college education fund, that mix may not be a goodmatch for long-term goals, such as retirement or estate planning.

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Likewise, investors with large sums of money often requirestrategies designed to address more complex needs, such as minimizing capitalgains taxes or generating reliable income streams. Furthermore, while investingin a single mutual fund provides diversification among the basic asset classesof stocks, bonds and cash (funds often hold a small amount of cash from whichthe fees are taken), the opportunities for diversification go far beyond thesebasic categories.

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With stocks, investors can choose a specific style, such asfocusing on large, mid or small caps. In each of these areas, stocks areadditionally categorized as growth or value. Additional selection criteriainclude choosing between domestic and foreign stocks. Foreign stocks also offersub-categorizations that include both developed and emerging markets. Bothforeign and domestic stocks are also available in specific sectors, such as biotechnologyand healthcare.

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

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While stocks and bonds represent the traditional tools forportfolio construction, a host of alternative investments provide theopportunity for further diversification. Real estate investment trusts, hedgefunds, art, precious metals, and other investments provide the opportunity toinvest in vehicles that do not necessarily move in tandem with traditionalfinancial markets. Yet, these investments offer another method of portfoliodiversification.

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Concerns

With so many investments to choose from, it may seem likediversification would be easy to achieve, but that is only partially true.Investors still need to make wise choices. Furthermore, it is possible toover-diversify your portfolio, which will negatively impact your returns. Manyfinancial experts agree that 20 stocks is the optimal number for a diversifiedequity portfolio. With that in mind, buying 50 individual stocks or fourlarge-cap mutual funds may do more harm than good.

The Bottom Line

Regardless of your means or method, keep in mind that thereis no single 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 all play a huge role in dictating yourinvestment mix. If you are too overwhelmed by the choices or simply prefer todelegate, there are plenty of financial services professionals available toassist you. (For related reading, see "The Importance Of Diversification")

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