How Investment Diversification Works

Allocating Your Investments

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.