What Is Portfolio Diversification?

When it comes to investing, savvy money managers advise that you spread your money around—that is, "diversify" your investments. Diversification protects you from losing all your assets in a market swoon. Putting all your eggs in one basket is a risky strategy.

But how should you diversify your portfolio? To diversify correctly, you need to know what kinds of investments to buy, how much money to put into each one, and how to diversify within a particular investment category.

What Does It Mean to Diversify Your Investments?

Having a lot of investments doesn't make you diversified. To be diversified, you need to have lots of different kinds of investments.

How to Diversify Your Portfolio

You should have some of all of the following: stocks, bonds, real estate funds, international securities, and cash.

Why Is It Important to Diversify?

Investments in each of these different asset categories do different things for you.

• Stocks help your portfolio grow.
• Bonds bring in income.
• Real estate provides both a hedge against inflation and low "correlation" to stocks—in other words, it might rise when stocks fall.
• International investments provide growth and help maintain buying power in an increasingly globalized world.
• Cash gives you and your portfolio security and stability.

How to Develop a Diversification Strategy

How do you figure out how much money to put into each investment category? Here are the rules of thumb for developing a diversification strategy.

What Are the Rules of Thumb for Developing a Diversification Strategy?

First, set aside enough money in cash and income investments to handle emergencies and near-term goals.

Next, use the following rule of thumb: Subtract your age from 100 and put the resulting percentage in stocks; the rest in bonds. In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds. (Most 401(k) plans contain both stock and bond offerings; you can also buy these investments through an IRA.)

How Diversified Should Your Portfolio Be?

Then, to diversify your money among the other investment categories, adjust the percentages you got using the above rule of thumb as follows:

• Invest 10% to 25% of the stock portion of your portfolio in international securities. The younger and more affluent you are, the higher the percentage.
• Shave 5% off your stock portfolio and 5% off the bond portion, then invest the resulting 10% in real estate investment trusts (REITs). Real estate investment trusts are a hybrid investment that produces stock-like average returns, although a large portion of the return is in dividends. The securities are volatile, swinging wildly in value. But, because they move at such a different pace than other investments, they can actually help stabilize returns.

The result: Our hypothetical 20-year-old would have an emergency fund and the remaining assets would be split 75% stocks (of which 25% were international), 15% bonds, and 10% REITs.

Diversify Within Investment Categories

Once you've diversified by putting your assets into different categories, you need to diversify again. It's not enough to buy one stock, for instance, you need to have a lot of different types of stocks in that portion of your portfolio. That protects you from being ravaged when a single industry—say, financial services or healthcare—takes it on the chin.

If you're not super rich, diversification while buying individual shares can be costly because you might have to pay trading fees each time you buy a different stock. The most cost-effective way for investors of modest means—and that means people who have less than $250,000 to play with—is to buy mutual funds.

Mutual funds are investment pools that combine the money of many individuals to buy stocks, bonds, real estate, international securities, and the like. To make things simple, you can buy so-called "index" funds, which purchase all the shares of a particular index, such as the stock market's Standard & Poor's 500 Index of big company stocks. There are also bond index funds, international indexes, real estate index funds, and money market funds, which are essentially an index fund for your cash.

Balancing Risk and Return

Diversification protects you from devastating losses, but it also costs you in average annual returns. That's because risk and reward go together in the financial markets. So, anything that reduces your risk will also reduce your return. Give yourself permission to take a little risk unless you're close enough to retirement that the additional security is particularly valuable.

Some people argue that the rule of thumb is too conservative because it suggests that a 50-year-old, who likely has another 30 years to invest, should have a 50-50 stock and bond mix. These people suggest a better rule of thumb is to subtract your age from 110.

The best strategy is one that's geared to you. If a little extra risk won't keep you up at night, this modified rule of thumb can work. But, if it will cause you distress, stick with the original rule of subtracting your age from 100, even if it isn't as lucrative. You'll save money on antacids.

Getting Help

This article discusses just a few possible strategies and tactics for diversifying your investment portfolio. However, ensuring your investment portfolio is sufficiently diversified can be tricky and risky. Be sure to use all available resources to assist you, such as reading investment books and meeting with financial advisors.