Step No. 3: Diversification

The key driver of your portfolio’s risk and return is your asset allocation between stocks and more conservative investments. The more you invest in stocks, the greater the swings in your portfolio’s value—but the higher your potential return.

How can you improve the odds of getting that richer reward? What can you do to lessen those wild price swings? That’s where diversification comes in. Put simply, diversification involves buying lots and lots of individual securities from all over the globe.

For instance, you can damp down your portfolio’s volatility if you diversify across U.S. stocks and foreign shares, including emerging markets. As mentioned earlier, different stock market sectors tend to be highly correlated. Still, when U.S. stocks tumble, maybe foreign markets won’t fall as much and perhaps a declining dollar might boost the value of foreign stocks for U.S. holders, thus helping to trim your portfolio’s overall loss.

Diversification also increases the chances you’ll be rewarded for the risk you are taking. If you purchase just a handful of stocks, it’s entirely possible you could earn wretched returns in a year when the overall stock market generates dazzling performance. In fact, if a company you own gets into financial trouble, you could lose everything invested in that stock.

As you increase the number of stocks you hold, the potential damage done by a few troubled companies becomes less and less. You also reduce your portfolio’s “tracking error.” In other words, it becomes more likely that your returns will approximate those of the broad market averages—and thus there is a greater likelihood you’ll get rewarded for the risk you are taking. What’s the ultimate in diversification? Some believe it’s the so-called global market portfolio.

Next: The Global Market Portfolio

Previous: Our Humble Opinion: Asset Allocation Guidelines

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