Diversifying your investment portfolio by selecting a variety of securities is another frequently used strategy. Done properly, diversification can reduce about 70% of the total risk of investing. Portfolio diversification refers to mixing up your investments to offset some risk. With portfolio diversification, you get two main advantages:
Portfolio diversification helps you minimize the potential of losing all your investment money if a stock, sector, or industry as a whole does poorly
Portfolio diversification helps you maximize the potential of doing really well if a stock, sector, or industry as a whole does well
One of the most effective ways to diversify an investment is with asset (stock) allocation, and it is a good way to help smooth out volatility in your portfolio. How does asset allocation work? Different asset classes (such as stocks and bonds) may respond differently to the same market conditions. This means if one part of a diversified portfolio does poorly it can be buffered by other investments that do relatively better. In other words, asset allocation helps spread the risk over several investments. The key to asset allocation is investing in assets with dissimilar performance. While the scientific and measurable investing principles of asset allocation are sound and are well proven, up until recently the process required some detailed mathematical calculations. Fortunately, the power of modern computers and specialized software make asset allocation much more accessible to a broader public. These computer-based programs store data about asset categories and class market histories, and then use the data to calculate optimal mixes of assets to meet the investor's personal risk tolerance and return requirements.
A properly diversified portfolio should include investments in a variety of industries and asset classes such as small-company stocks, international government bonds, and fixed annuities.
