How To Diversify Your Investments

Investment diversification protects your money from adverse stock market conditions.

When it comes to investing, savvy money managers advise that you spread your money around -- that is, “diversify” your investments. Diversification protects you from losing all your assets in a market swoon. The sharp decline in stock prices in 2008 is proof enough that it's something you must do.

But in order to diversify correctly, you need to know what kinds of investments to buy, how much money to put into each one, and how to diversify within a particular investment category.

Go for Variety, Not Quantity

Having a lot of investments does not make you diversified. To be diversified, you need to have lots of different kinds of investments. That means you have to have some of all of the following: stocks, bonds, real estate funds, international securities, and cash.

Investments in each of these different asset categories do different things for you.

• Stocks help your portfolio grow.
• Bonds bring in income.
• Real estate provides both a hedge against inflation and low "correlation" to stocks -- in other words, it may rise when stocks fall.
• International investments provide growth and help maintain buying power in an increasing global world.
• Cash gives you and your portfolio a sense of security.

How to Allocate Your Money

How do you figure out how much money to put in each investment category?

First, set aside enough money in cash and income investments to handle emergencies and near-term goals. Next, use the following rule of thumb: Subtract your age from 100 and put the resulting

percentage in stocks; the rest in bonds. In other words, if you're 20 years old, put 80% of your assets in stocks; 20% in bonds. (Most 401(k) plans have both stock and bond offerings; you can also buy these investments through an IRA.)

Then, in order to diversify your money among the other investment categories, adjust the percentages that you get using the above rule of thumb as follows:

• Invest 10% to 25% of the stock portion of your portfolio in international securities. The younger and more affluent you are, the higher the percentage.
• Shave 5% off your stock portfolio and 5% off the bond portion and invest the resulting 10% in real estate investment trusts (REITs). Real estate investment trusts are a hybrid investment that produces stock-like average returns, although a large portion of the return is in dividends. The securities are volatile, swinging wildly in value. But, because they move at such a different pace than other investments, they can actually help stabilize returns.

The result: Our hypothetical 20-year-old would have an emergency fund and the remaining assets would be split 75% stocks (of which 25% were international), 15% bonds, and 10% REITs.

Diversify Within Investment Categories

Once you've diversified by putting your assets into different categories, you need to diversify again. It's not enough to buy one stock, for instance, you need to have a lot of different types of stocks in that portion of your portfolio. That protects you from being ravaged when a single industry -- say, financial services or health care -- takes it on the chin.

If you're not super rich, diversification while buying individual shares can be costly, because you pay trading fees each time you buy a different stock. The most cost-effective way for investors of modest means -- and that means people who have less than $250,000 to play with -- is to buy mutual funds.

Mutual funds are investment pools that combine the money of many individuals to buy stocks, bonds, real estate, international securities, and the like. To make things really simple, you can buy so-called "index" funds, which purchase all the shares of a particular index, such as the stock market's Standard & Poor's 500 Index of big company stocks. There are also bond index funds, international indexes, real estate index funds, and money market funds, which are essentially an index fund for your cash.

Balancing Risk and Return

Though diversification protects you from devastating losses, it also costs you in average annual returns. That's because risk and reward go hand-in-hand in the financial markets. So anything that reduces your risk will also reduce your return.

How much does it cost you? That depends on how much you diversify and on market conditions when you do. Data from Ibbotson Associates, a Chicago-based market research firm, can provide a glimpse.

According to Ibbotson, a portfolio of big company stocks gained an average of 10.4% per year since 1926. A portfolio made up of half stocks and half government bonds returned 8.4%. In dollars and cents: If you had invested $10,000 in the all-stock portfolio, you could have cashed out 30 years later with a nest-egg worth a cool $194,568. If you put your investments in 50% stocks and 50% bonds, you would have had far fewer money-losing years, but your total nest-egg would be worth just $112,429 at the end of the period. That's nearly 73% less than the all-stock portfolio.

To lose so much potential return makes little sense, unless you're close enough to retirement that the additional security is particularly valuable. And that’s where the age-based rule of thumb comes in (see “How to Allocate Your Money,” above).

Some people argue that the rule of thumb is too conservative because it suggests that a 50-year-old, who likely has another 30 years to invest, should have a 50-50 stock and bond mix. These people suggest a better rule of thumb is to subtract your age from 110.

The best answer is one that's geared to you. If a little extra risk won't keep you up at night, this modified rule of thumb can work. But, if it will cause you distress, stick with the original rule of subtracting your age from 100, even if it isn't as lucrative. You'll save money on antacids.