DIVERSIFICATION

"Diversification" sounds like a simple-enough term. You diversify when you add variety to a group—for example, your company may diversify by adding an entirely new product line. But simply creating a new version of an old product is not diversification. Diversification does not mean more of the same thing.

In finance, diversification is investing in instruments that are backed by different kinds of assets.

A diversified portfolio could include different categories of investments (stocks, bonds, etc.), stocks of different industries, different nations, and so on. Diversification decreases risk by limiting the chance that any one set of economic factors will have a major negative impact on the value of your portfolio.

Sometimes people get caught in the trap of "more is better." They think that if they own shares in one automobile company, they can lessen their portfolio's risk by adding stock from another automaker. While this does reduce the risk of one automaker's bad fortune, it does not reduce the risk of a downturn in the auto industry. Remember, diversification is not piling more eggs into your basket; in fact, this exacerbates the problem. Diversification is putting your eggs into different baskets.

The idea is to moderate a portfolio's volatility by including investments that do not move in lockstep. For instance, two food company stocks might tend to rise and fall at the same time in the market; so a portfolio with many similar holdings would have more drastic fluctuations—and be more volatile—than one with diversified holdings across different industries.

Most investors aim to balance their portfolios with a combination of different assets—such as U.S. stocks, bonds, international stocks, and other investments. When one type of asset is generally experiencing a downturn or period of slow growth, other assets can compensate with higher-than-average growth. The aim is to create a portfolio with steady overall growth, rather than one that is up one year and down the next. In the long run, this synergy will produce good returns with lower risk.

Diversification can help you set and direct an investment path that meets your financial goals. Click to the next screen to learn about more investment strategies.