What Is Diversification?
If you've ever heard the old adage about "not putting all of your eggs in one basket," you're already well acquainted with the concept of diversification. Diversification is incredibly important when it comes to investing, because a properly diversified portfolio will weather markets much better than one that is too narrowly focused.
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Function
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Diversification is a way of stabilizing your investment portfolio and reducing risk. The stock and bond markets are made up of shares of thousands upon thousands of different companies and debt instruments, each of which has its own risk profile and benefits. If you invest in only a handful of companies (for instance, just the company you work for), you are betting that those companies will never hit a rough patch or go out of business. By investing in lots of different types of stocks, it matters less when one or two companies fail, because you have plenty of other investments that are doing well.
Types
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There are many ways to diversify your portfolio. The stock market is divided into asset classes (like large-cap, small-cap, growth, value, international, domestic, real estate and more), as is the bond market, and a smart asset allocation strategy incorporates a small piece of all of these asset classes. You can do this with individual stocks (by buying the stock of one or more companies from each asset class) or with mutual funds.
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Benefits
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Mutual funds offer the best bang for your buck when it comes to diversification. Because there is no limit on how many stocks may be included in a mutual fund, they have unlimited diversification possibilities. For instance, there are mutual funds that hold the stock of EVERY company in the New York Stock Exchange (often called Total Stock Market Index Funds). There are also mutual funds that focus on a very specific asset class, such as REIT funds or Small-Cap Value Funds. The name of the underlying asset class is often included in the name of the fund, but if it's not, you can find out the asset class by researching the funds' holdings or asking a representative from the mutual fund company.
Considerations
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You can also diversify your portfolio by allocating part of your money to bonds or other fixed-income investments. Mutual funds containing bonds are widely available. A portfolio containing 60 percent stocks (or stock mutual funds) and 40 percent bonds (or bond mutual funds) is the "classic" balanced portfolio, but each investor must tailor this balance to his or her specifications; 40 percent bonds may not be aggressive enough for young investors, while older investors may want less than 60 percent stocks to preserve principal.
Warning
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While it is possible to assemble a properly diversified portfolio with single stocks, most novice investors don't have the intimate knowledge of the stock market required to complete this task successfully. Also, since individual stocks can cost hundreds of dollars each, those with small portfolios may find it difficult to purchase enough individual stocks to create an adequately diversified investment plan.
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