Diversification simply means dividing your investments among a variety of types. It's one of the best ways to protect your portfolio from the pendulum swings of the economy and the financial markets. Since your portfolio will hold many different securities, a decline in the value of one security may be offset by the rise in value of another. For example, bonds often perform well when stocks are performing poorly.
No matter how diversified your portfolio, you can never completely eliminate risk. You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock, so it is important to also diversify among different assets. The key is to find a medium between risk and return.
Diversification takes different forms. For example, you can diversify your common stock holdings by purchasing stocks representing many different industries. That would be safer than concentrating in a single sector, such as holding only technology stocks. You can diversify your bond holdings by buying a mixture of high-quality bonds and some lower-rated bonds. The high-quality bonds tend to reduce the overall risk associated with the bond portfolio, while the lower-rated bonds may increase your overall returns (as they typically pay more interest).
You can also diversify with time. For example, your portfolio could include thirty-year corporate bonds and five-year Treasury notes. Long-term bonds typically offer higher interest rates than short-term ones, but short-term investments give you more flexibility to take advantage of fluctuating interest rates.
Preferred stock (which you'll learn more about in Chapter 4) is often considered a fixed-income investment, even though it's technically an equity investment. That's because preferred stock shares typically come with fixed, guaranteed dividend payments, a form of steady income. In fact, preferred stock is sometimes referred to as “the stock that acts like a bond.”
Another important form of diversification is obtained when you invest in different types of securities — stocks, bonds, real estate, and money market instruments, to name the major investment types or asset classes. Diversifying your holdings over several asset classes, particularly among those that tend to perform differently under the same economic circumstances, adds an extra layer of protection to your portfolio.