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 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 from two different companies, you can reduce the potential risk to your portfolio.

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 towards a mix of 80 percent stocks and 20 percent bonds, while conservative investors may prefer a 20 percent stocks to 80 percent 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 reliable way to create a diversified portfolio. Some mutual funds aim to have a mix of securities that includes both stocks and bonds to create ready-made "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.

What Are My Options?

If you are a person of limited means, or if 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 the fees are taken), the opportunities for diversification go far beyond these basic categories.

With stocks, investors can choose a specific style, such as focusing on large, mid or small caps. In each of these areas, stocks are additionally categorized as growth or value. Additional selection criteria include choosing between domestic 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 healthcare.

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, precious metals, and other investments provide the opportunity to invest in vehicles that do not necessarily move in tandem with traditional financial markets. Yet, these investments offer another method of portfolio diversification.

Concerns

With so many investments to choose from, it may seem like diversification would be easy to achieve, but that is only partially true. Investors still need to make wise choices. 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 of the investments to have much of an 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 a more careful fund selection.

The Bottom Line

Regardless of your means or method, keep in mind that there is 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 your investment mix. If you are too overwhelmed by the choices or simply prefer to delegate, there are plenty of financial services professionals available to assist you. (For related reading, see "The Importance Of Diversification")