Talk to most any financial planner, and within the first five minutes he’ll mention diversification, then keep going. Most people expect he means something like “don’t put all of your money into one stock,” which is good advice … but incomplete.
Diversification does mean divvying up your investments among a variety of types – it’s a good way to protect your portfolio from major pendulum swings in the economy and the financial markets. Since you’ll be holding a lot of different securities, when the price of one drops, it may be offset by an increase in value of another. For example, bonds tend to perform well when stocks don’t.
But that’s not the only way to diversify your holdings. You can also diversify your common stock holdings by purchasing stocks in several different industries, which is safer than concentrating in a single sector, like holding only tech stocks. You can diversify bond holdings by getting a mix of high-quality bonds along with some lower-rated bonds: The high-quality bonds can reduce the overall risk of the bond portion of your portfolio, while the lower-rated bonds can increase your overall returns because they pay more interest.
You can also diversify with time; you could buy thirty-year corporate bonds and five-year Treasury notes. Long-term bonds usually offer higher interest rates because you’re locked in for the long haul, but short-term investments offer more flexibility so you can take advantage of fluctuating interest rates.
Another way to protect your portfolio from total annihilation is to hold different types of securities, like stocks, bonds, real estate, and commodities. Holding diverse asset classes, particularly a mix of those that tend to perform differently under the same economic circumstances, can add an extra layer of profit protection to your portfolio.