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.