Diversification

When you've decided on an allocation among the asset classes you've selected, the next step is diversification. Each asset class contains subclasses that vary in risk and potential return. Within the stock market, stocks of new start-up companies have greater potential for volatility and growth than well-established, blue chip company stocks. In the bond market, U.S. Treasuries promise more protection than investment-grade corporate bonds, which offer greater stability than junk bonds (high yield, high risk bonds).

The key to diversification is spreading your money among different sectors, industries and securities within a number of asset classes. A well-diversified bond portfolio, for example, might include government bonds, high-grade and high-yield corporate debt from companies in different sectors and international bonds. This way, if one aspect of the portfolio performs poorly, other investments may act inversely to mitigate some of the losses. Although a well balanced portfolio may help spread the risk during market fluctuations, it does not assure a profit, or protect against loss, in a down market.

Diversification Models

Different life circumstances dictate different portfolio balances. What might be well balanced for one person might be too heavily invested in one asset class for another. You should determine what you're most comfortable with and what will work best for your individual financial situation.

The Efficient Frontier

The economic concept of the efficient frontier maintains that there are combinations of securities that maximize return for any given level of risk. This means that while there may be many securities with the same level of risk, it is only the optimal bundle that maximizes return that reaches the efficient frontier. No combination of asset classes that lies on the frontier is any better than another because investors have different risk tolerances. Any bundle that is not included on the frontier, however, is considered suboptimal. Economist Harry Markowitz pioneered the concept in 1952 and led the way for Modern Portfolio Theory.