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With the stock markets bouncing up and down 5% every week, individual investors clearly need a safety net. Diversification can work this way and can prevent your entire portfolio from losing value.

Diversifying your portfolio may not be the sexiest of investment topics. Still, most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-range financial goals while minimizing your risk. Keep in mind, however that no matter how much diversification you do, it can never reduce risk down to zero. (For related reading, see Introduction To Diversification and The Importance Of Diversification.)

What do you need to have a well diversified portfolio? There are three main things you should do to ensure that you are adequately diversified:

  1. Your portfolio should be spread among many different investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate.
  2. Your securities should vary in risk. You're not restricted to picking only blue chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas. Keep in mind that this doesn't mean that you need to jump into high-risk investments such as penny stocks!
  3. Your securities should vary by industry, minimizing unsystematic risk to small groups of companies.
    Another question people always ask is how many stocks they should buy to reduce the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified stocks, you are very close to optimal diversification. This doesn't mean buying 12 internet or tech stocks will give you optimal diversification. Instead, you need to buy stocks of different sizes and from various industries.

Next: Risk and Diversification: Conclusion »


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