One thing even new investors understand (or have at least heard of) about a portfolio is the concept of diversification — blending a variety of asset classes to reduce exposure to risk. But a well-diversified stock portfolio is just one component of putting together the best possible investment portfolio.

Diversifying not just among different stocks, but utilizing different types of assets, is how an investor can truly mitigate risk. Even with a well-diversified stock portfolio, an individual is still exposed to market risk (or systematic risk as finance professors like to call it), which cannot be reduced by adding additional stocks.

What Exactly Is Diversification?

Diversification works by spreading your investments among various asset classes (e.g. stocks, bonds, cash, T-bills, real estate, etc.) with low correlation to each other. This allows you to reduce volatility in your portfolio, because different assets move up and down in price at different times and at different rates. Thus, having a portfolio diversified across different asset types creates more consistency and improves overall portfolio performance.

How Does Correlation Work?

Correlation is simple: If two asset classes are perfectly correlated, they are said to have a correlation of +1. This means that they move in lockstep with each other, either up or down.

A completely random correlation — a relationship in which one asset's chance of going up is equal to the chance of dropping if the other asset rises or falls — is said to be a correlation of 0.

Finally, if two asset classes move in exact opposition — for every upward movement of one there is an equal and opposite downward movement of another, and vice versa — they are said to be perfectly negatively correlated, or have a correlation of -1.

Diversified Stock Portfolio vs. Diversified Portfolio of Assets

When we talk about diversification in a stock portfolio, we're referring to an investor's attempt to reduce exposure to unsystematic risk (i.e. company-specific risk) by investing in various companies across different sectors, industries or even countries.

When we discuss diversification among asset classes, the same concept applies, but over a broader range. By diversifying holdings across different asset classes, you are reducing the risk of being exposed to the systemic risk of any one asset class.

Like holding one company in your stock portfolio, having your entire net worth in a portfolio of any one asset (even if that portfolio is diversified) constitutes the proverbial "all of your eggs in one basket." Despite the mitigation of unsystematic risk (risk associated with any individual stock), you are still very much exposed to market risk. By investing in a number of different assets, you reduce this exposure to market risk or the systemic risk of any one asset class.

Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt toward your long-range financial objectives.

How to Diversify Your Portfolio

Up to this point we have talked more in a theoretical sense. Now, let's look at some examples to sink your teeth into.

Bonds are a popular way to diversify due to their very low correlation with some of the other major asset classes, particularly equities. Other fixed-interest investments such as T-bills, bankers' acceptances and certificates of deposit are also popular.

Another viable option is real estate, which has a relatively low correlation with the stock market. Using real estate as an asset to diversify a portfolio is an excellent and practical investment, largely due to the fact that many people (through their homes or otherwise) are invested in the real estate market.

It's amazing how many people tend to overlook the investment potential of this asset. Investing in real estate doesn't mean that you need to go out and purchase a house or building, although that is a viable option for entering this market.

As an alternative to a direct property purchase, individuals can invest in the real estate market through real estate investment trusts, or REITs. REITs sell like stocks on the major exchanges, and they invest directly in real estate through properties or mortgages. REITs typically offer investors high yields as well as high liquidity. Because of the real estate market's relatively low correlation with the stock market, by investing in a REIT, an individual can diversify away some the stock market's inherent risk.

Real estate (and more specifically REITs) is just one of the means to accomplish this reduced exposure to risk. As the illustration above demonstrates, investors have a number of different options that can all help reduce the risk of investing in any one asset class.

The Bottom Line

Diversification is a key building block to anyone's financial plan, including understanding what diversification does and how it helps an individual's overall financial position. It is crucial that investors know the difference between systematic and unsystematic risk, as well as understand that by diversifying among asset classes, they can mitigate exposure to systematic risk.