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A diversified portfolio does not concentrate in one or two investment
categories. Instead, it includes some investments whose returns zig while the
returns of other investments zag. The net effect is lower volatility in returns.
An example of a concentrated portfolio is one that is invested entirely in
technology stocks. Sure, having a lot of tech "exposure" seemed like a wise
strategy when the tech-heavy NASDAQ was posting annual gains of well over 20% in
the late 1990s. However, when the tech bubble burst in early 2000, investors
holding tech-heavy portfolios took a drubbing that they've yet to recover from.
There are different ways to diversify a portfolio. One way is to start by
allocating a target percentage of your total investment portfolio to stocks,
bonds and cash. To help you, brokerages typically publish their recommended
allocations.
For example, An investor with a shorter investment horizon would be more
cautious. They might decide to allocate 60% to stocks, 30% to bonds and 10% to
cash.
At the next stage, you may decide to allocate to various investment categories
within each major asset class. For example, the aggressive investor may allocate
half of their stock allocation to each growth and income funds. The conservative
investor may decide to allocate half of their bond allocation to each government
and muni bond funds.
Successfully diversifying your portfolio means investing in securities whose
investment returns do not move together. That's what investing in different
asset classes helps to accomplish. To diversify, you'll want to invest in
securities whose returns on such securities have low or negative correlation.
The correlation coefficient is used to measure the degree that the returns of
two securities are related. Two stocks whose returns move together in lockstep
have a coefficient of +1.0. Two stocks whose returns move in exactly the
opposite directions have a correlation of -1.0. To effectively diversify, you
should aim to find investments that have a low positive correlation, zero
correlation or negative correlation.
A more widely available measure, beta, can be used to help achieve a diversified
portfolio. The beta of the stock market index, which represents a fully
diversified portfolio, is 1.0. A stock's beta of 1.0 signifies that its price
changes in lockstep with price changes in the market index. A beta of 1.2
signifies that the stock price moves 1.2 times as much as the market index in
the same direction. A diversified portfolio has a beta of 1.0, similar to the
beta of the market index.
As the number of securities in your portfolio increases, you reach a point where
you've likely diversified as much as you possibly can. This point represents a
fully diversified portfolio. Financial experts vary in their views on how many
securities it takes to achieve a fully diversified portfolio. Some professionals
say this number is 10 to 20 securities, while others say it is closer to 30
securities.
Whether you build a portfolio of 10 or 30 securities, you still incur
transaction costs such as brokerage fees to buy the securities. For example, if
the average trade costs $30, building a 10-stock portfolio would cost $300 in
commissions.
Mutual funds can often provide greater diversification at a lower cost than
buying individual securities. You can often buy shares of a no-load mutual fund
directly from the fund or a brokerage firm.
Keep in mind that mutual funds generally require an initial investment of $1,000
to $2,500. (You can usually make additional investments of as little as $25.)
The Web site of the Investment Company Institute (www.ici.org) keeps a list of
mutual funds and their toll-free numbers.
Mutual funds often concentrate their portfolios in one investment category. As a
result, you still need to allocate among a few mutual funds to gain the full
benefits of diversification.
An alternative to investing in an actively managed mutual fund is to invest in
an index fund. An index fund mimics the performance of the index it is named for
because its portfolio composition is identical to the index. Index funds have
lower expenses than actively managed funds since they trade less frequently and
require less research and portfolio administration.
This information should not be interpreted as financial advice. For advice that
is specific to your circumstances, you should consult a financial or tax
adviser.
» The Asset Allocation Process
» Asset Allocation - Portfolio Diversification
» Asset Allocation - Measuring Your Risk Tolerance
» Asset Allocation - Rebalancing Your Portfolio
» Asset Allocation - Taxes & Inflation
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Asset Allocation - 
