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How Investment Diversification Works


Choosing Asset Classes
A financial professional monitors stocks at the New York Stock Exchange on March 31, 2009.
A financial professional monitors stocks at the New York Stock Exchange on March 31, 2009.
Chris Hondros/Getty Images

The textbook definition of investment diversification is to build a portfolio of investments from a variety of asset classes. The three major asset classes are stocks, bonds and cash. The idea is to choose a combination of these three assets that produces the ideal level of risk. No risk means no growth, but too much risk means the potential exists for swift financial disaster.

Stocks are generally the riskiest of the three asset classes. They are divided into small cap, mid cap and large cap stocks based on the size of the company ("cap" is short for market capitalization). Stocks are also categorized by their style. Labels such as growth, value, international and blend help identify the relative risk and growth potential of the stock.

Bonds are sold by the government and private companies and come with different maturity dates (from less than a year to 30 years). Bonds are less risky than stocks and therefore offer lower returns. Bonds with lower credit ratings, also known as junk bonds, might carry higher interest rates, but run the risk of defaulting.

Cash investments include any highly secure, low-interest account like a savings account at the bank or a money market account. The risk with cash accounts is close to zero.

On the next page, we'll talk about allocation, the process of choosing how much of your portfolio to invest in each asset class.