Diversifying your Portfolio

The goal of diversification is to reduce the risk involved in building a portfolio.

Volatility is limited by the fact that not all asset classes or industries or individual
companies move up and down in value at the same time or at the same rate. While
this limits the rate of growth as well, it reduces the likelihood of substantial losses
and allows for more consistent performance under a wide range of economic
conditions.
Devising an asset allocation plan is the first step toward diversifying a portfolio.
Dividing funds between different asset classes provides some protection against
loss when one type of investment is underperforming. Because the values of
different investments often move in opposite directions, investing in a range of
securities will be decreasing in value at the same time. The process of
diversification, however, does not end with asset allocation. Within asset classes, it
is important to purchase securities from a variety of industries, so that poor
performance in one area will not send an entire portfolio reeling. Certain industries
perform better under certain economic conditions, but a diverse portfolio should
continue to build overall value under almost any conditions. Diversification should
then continue even within industries by purchasing securities from a mix of
companies that serve different roles within the industry. A single stock in a highflying industry may still fail, but a group of ten diverse stocks within that industry
will
have
lower
volatility
than
just
one
would.
Learning enough about the many industries and companies that make up a diverse
portfolio is no easy task. A great deal of research is required to make good
decisions. For investors who wish to learn about a few specific areas to pick
individual investments, mutual funds can fill in the gaps. Professionals design
mutual funds to have a great deal of diversification built in. Even mutual funds that
focus on a particular part of a particular industry will usually provide the chance to
invest in a broad section of that sector.
Index funds provide another option for diversification by giving investors the
opportunity to invest in all of the stocks that appear in a certain index. While these
funds vary widely in terms of the stocks they cover, they all provide the opportunity
to tie the returns on invested funds to the performance of a large number of
individual stocks. These funds differ from the actively managed funds discussed
above in that the contents of the funds are determined independently by whoever
maintains the index instead of relying on a fund manager who has the power to
make decisions about where to invest the money