How Investment Diversification Works

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.

There's no single formula for allocating your investments. Allocation depends heavily on the amount of risk with which you're comfortable. It also depends on your stage in life as an investor. If you're just starting out and you have 20 or more years before you'll need to start cashing in your investments, then your allocation will be much different than someone who's a year away from retirement.

As a general rule, the younger you are, the more risk you can take with your investment portfolio. This is because you have the luxury of time. Even if you have a few bad years with the stock market, you can still rely on the magic of compound interest to grow your investments considerably over the long term.

For a young investor who has 15 or more years until she has to start paying for her child's college education or her own retirement, she will allocate the majority of her portfolio to stocks. Some young investors even invest 100 percent of their assets in stocks at the beginning.

As an investor gets a little older, perhaps after he gets married or has his first child, he may want to secure his investments a little more by allocating 80 percent of his portfolio to stocks and 20 percent to bonds. As college or retirement appears on the horizon, some investors will overcome even more conservative, perhaps allocating 60 percent of his assets to stock and 40 percent to bonds.

When an investor is just a few years away from retirement, she might want to switch all of her holdings to bonds and cash accounts. Hopefully the investor has built up a nice nest egg by now. The worst thing to happen at this point would be for a stock market crash to wipe out all of her savings. So even though her money will grow at a slower rate, it's better to keep it safe in low-risk, low-interest bonds and cash.

It's not enough, however, to only diversify your investments across the asset classes. You also need to diversify within each class. Keep reading to find out how.

Diversification within each asset class is the key to a successful, balanced portfolio. Through careful research, you need to find assets that work well with each other. True diversification means having your money in as many different sectors of the economy as possible.

With stocks, for example, you don't want to invest exclusively in big established companies or small start-ups. You want a little but of both (and something in-between, too). Mostly, you don't want to restrict your investments to related or correlated industries. An example might be auto manufacturing and steel. The problem is that if one industry goes down, so will the other.

With bonds, you also don't want to buy too much of the same thing. Buying tons of 30-year Treasury Bills is fine, but it's not the way to maximize your return on investment. Instead, you'll want to buy bonds with different maturity dates, interest rates and credit ratings.

A good way to diversify your holdings within an asset class is to use something called a style chart [source: Wells Fargo]. A style chart is a simple table you can make with pencil and paper or with a spreadsheet program like Excel.

To make a stock style chart, for example, you'd create a table with "market cap" on the horizontal axis and "style" on the vertical. Under market cap, create three columns labeled "small cap," "mid cap" and "large cap." Under style, create three rows labeled "value," "blend" and "growth."

Now look for stocks that satisfy each section of the chart; for example, a "small-cap value" stock or a "mid-cap blend" stock. It's an easy way to see that you've covered all of your bases. You can do the same with bonds, using maturity dates and credit ratings as criteria.

Obviously, it requires a serious amount of research to figure out which stocks and bonds to buy. If you're new to investing, it might be worth it to consult with an investment counselor or money manager before you make any big decisions with your money.

Congratulations! You've created a diversified investment portfolio. If only your work stopped there... Keep reading to learn about an important investment diversification concept called rebalancing.

Car manufacturers recommend that you get your tires balanced every 5,000 miles (8,047 kilometers). The same is true for your investment portfolio. About once a year, you should rebalance your portfolio to make sure that your investment allocations are still where you want them to be.

Now you may be wondering, "If I didn't change my allocations, why would they be different?" That's because, as an investor, you only control how much money you put in to the system. The market controls how much money you actually have at any given time. If I invest $1,000 today in IBM stock, that same stock could be worth more or less money in a week, a day or even an hour.

The only way for your allocations to remain the same is for each of your assets to grow or shrink at the same rate. With so many different investments and so many different financial variables, that's not likely to happen. That's why you need to periodically rebalance your portfolio to restore your allocations to their original percentages.

Let's look at an example. When you created your portfolio a year ago, you allocated 60 percent to stocks and 40 percent to bonds. Looking at your year-end statement, your total investment portfolio grew 15 percent over the year. Congratulations! But upon closer inspection, while your stocks did great, your bonds actually limped along for a loss. The result is that more than 60 percent of your total money is now in stocks and less than 40 percent is in bonds.

Now, instinct might tell you to leave your portfolio the way it is. After all, isn't it smart to keep more money in the assets that are doing well? While that logic might make sense in the short term, it doesn't hold up in the long term.

Read more about the logic of portfolio rebalancing in the next section.

Bottom line, it's impossible to predict what the market will do from year to year. Past performance, as they say, is no indication of future success.

Think back to a year ago when you first allocated the assets in your portfolio. You chose to invest 60 percent of your portfolio to stocks because you decided it was the right amount of risk. Now, because of the way your investments performed over the past year, your portfolio contains more than 60 percent of your money in stocks. Essentially, you've increased your risk. If stocks take a nosedive next year, then you've left yourself vulnerable.

The logic of rebalancing your portfolio might seem illogical at first. After all, you're essentially selling the assets that are doing well and buying more of the assets that are doing poorly [source: The Wall Street Journal]. By restoring your assets to their original percentages, you are ensuring the same level of risk over the long term. If you didn't rebalance your portfolio, your money would blindly chase the winds of the market.

Another logic of rebalancing has to do with the central tenet of investing: Buy low and sell high. By buying more in low-performing assets, you get more for your money. For example, if you buy $1,000 of IBM stock at $1 a share, you get 1,000 shares. If you waited to buy the same stock at $10 a share, you'll only get 100 shares. By buying when stocks are low, you get more shares and therefore more potential for long-term growth.

For most investors, it's enough to rebalance once a year [source: Carther]. But you should always consider the cost of rebalancing. Buying and selling stocks and bonds requires a broker or an online trading account. Both carry fees for each trade. If your portfolio isn't terribly out of whack, you might want to wait to rebalance until it's worth the transaction fees.

If all of this talk of style charts and rebalancing is giving you a headache, you might want to consider mutual funds. We'll talk more about these diversification timesavers on the next page.

Mutual funds are wildly popular with investors because they offer instant investment diversification. A mutual fund is a collection of stocks and bonds managed by a team of professional investors and money managers. The professionals do all of the research for you. They pick and choose assets that achieve a desired ratio of risk and growth potential. Even better, mutual funds rebalance themselves!

Mutual funds have their disadvantages, too. Not all mutual fund managers are created equal, so there's no guarantee that your collection of stocks and bonds will make money. Also, not all mutual funds are cheap. Many carry lots of sneaky commissions and hidden fees with disarming names like "back-end loads" [source: Investopedia].

Equity funds are mutual funds that are composed mostly of stocks and are allocated for long-term growth. Within equity funds are a number of subcategories:

Income mutual funds are less risky than equity funds. They invest in mostly government and corporate bonds and are designed for people who are willing to sacrifice growth potential for a steady dividend paycheck. Money market accounts are also a type of mutual fund that only invests in the most conservative security: U.S. Treasury Bills.

Targeted maturity funds are designed for investors who are saving for a particular time-sensitive goal like retirement or paying for a college education. With names like "Target Retirement 2040," these mutual funds are automatically balanced and allocated to maximize return and secure your earnings by 2040 [source: Pulliam Weston].

Take note that if you invest in a mutual fund outside of a tax-sheltered 401(k) or IRA account, you will be subject to capital gains tax each time your fund manager sells assets to invest money in other securities. The best funds for avoiding capital gains taxes are index funds since they require less maintenance [source: Barker].

Now let's wrap things up by considering both the advantages and disadvantages of investment diversification.

Let's start with the bad news. Investment diversification guarantees (guarantees!) that you won't achieve the greatest return on investment possible. It's extremely unlikely that all of your different investments across various asset classes will all skyrocket. At least one of them is going to do worse than the rest, so get used to it.

When the stock market is really doing well (known as a bull market), investment diversification can appear overly conservative to some investors. After all, why put money in low-interest bonds and money market accounts when the market is so hot?

Another argument against diversification is that it isn't even an effective way to secure your money against a true financial collapse. Thanks to the recent global financial crisis, nearly all of the 69 mutual funds tracked by Morningstar were down in 2008 [source: Updegrave]. From early 2008 to early 2009, both large and small-cap stocks have lost 38 percent of their value and international stocks have lost more than half of their value [source: Bernstein].

So if investment diversification holds you back during bull markets and leaves you unprotected during bear markets, then what's the point?

The point is that investment diversification provides a cushion. You may not fully cash in during the fat years, but you won't go broke during the lean years. For example, an investor who had 100 percent of his portfolio in stocks in 2008 would have lost 40 percent of his holdings. If that same portfolio were diversified into 60 percent stocks, 30 percent bonds and 10 percent cash, it would only have lost 20 percent of its value [source: Updegrave]. That's a big difference.

Also, investment diversification isn't about the short-term ups and downs of specific financial markets. It's about the long-term performance of a broad variety of assets. Throughout all of the economic peaks and valleys of a lifetime, diversification still wins.

William J. Bernstein made an interesting point in a March 2009 Money Magazine article. If you could go back in time to 1998 knowing what you know now, that the U.S. financial markets would suffer two serious recessions in the next decade, you might be tempted to put all of your money in ultra-secure Treasury Bills. Incredibly, a well-diversified stock portfolio would still outperform T-Bills over that same woeful decade [source: Bernstein].

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