This simplified chart illustrates the advantages of diversifying within an asset class. If you invest in several subclasses, or categories, of stock, for example, you help protect your portfolio value against disappointing returns from one subclass while taking advantage of the stronger performance of another. In some periods, as the chart shows, all stock subclasses may gain or lose value at the same time, though the rates of return may vary. But, in other periods, one subclass might post a loss while another has a gain. This pattern of constant variation in the rate of subclass return is true across the range of asset classes.

Investment performance tends to move in recognizable patterns, though not on a predictable schedule. In any period of time, while some of your investments are living up to expectations, others may be providing disappointing returns. If you want your portfolio, or combined group of investment holdings, to provide the best possible return while also limiting the risk of major losses, you have to diversify, or spread your principal among different investments within the asset classes, such as stocks, bonds, and cash, you've selected.

That's because any time all of your money is concentrated in one or two investments, your financial security depends entirely on the strength of those investments. And no matter how sound an investment may be, there will be times when its market price falls, or it yields less than the rate of inflation, or both.

For example, if your life savings are in certificates of deposits (CDs) paying 3%, while inflation is also around 3%, you're facing a loss of buying power. Or if you own hundreds of shares in a company that loses money, cuts its dividend, and drops in value in the stock market, you'll be short dividend income and perhaps part of your original investment if you sell your shares.

THE FIRST STEPS
Allocating your investment assets is no easy matter. For starters, you need enough money to make a variety of investments. And, you have to judge each individual investment not only on its own merits, but in relation to the rest of your portfolio.

If you put some of your long-term investment money into fixed-income investments like corporate or municipal bonds, you may also want to make equity investments like stocks or stock mutual funds. If some of your short-term investments are CDs, you may want to put the rest in money market funds or US Treasury bills.

THE SECOND STAGE
Diversification also means spreading your investment dollar within a specific type of investment. For example, your stock portfolio is not diversified if you own shares in just one or two companies, or in companies all involved in the same sector of the economy, like healthcare or utility companies. Nor are your fixed-income investments diversified if you own only municipal bonds issued by the state in which you live. If you invest in five mutual funds, but they all track small growth companies, you're not diversified either.

Many financial advisers suggest that real diversification also calls for international investments. Because world economies respond primarily to what's happening in their own countries or regions, putting money into overseas markets is a good way to balance what's happening at home and take advantage of the growth potential in those markets.

One of the most convenient ways to invest in overseas markets is to buy American Depository Receipts (ADRs), stock in overseas companies listed directly on US exchanges, stock in US companies with major international markets, or international mutual funds. ADRs are also known as American Depositary Shares (ADSs). Remember, though, that currency fluctuations and potential political or civil unrest could affect the value of your investments.

ASK YOURSELF Achieving diversity isn't a one-shot deal. In analyzing your portfolio, ask yourself the following questions to measure where you are and what's next: What resources have I committed to buying stocks, bonds, mutual funds, real estate, and other investments? What are those investments worth in relation to each other? How about in comparison to last year? Five years ago? Ten years ago? What investments have I made lately? Are they all basically the same? Or am I continuing to diversify? What am I going to buy next? Why?

THE VALUE OF FUNDS
One of the reasons mutual funds keep cropping up in discussions of diversification is that they are internally diversified. Each fund may own dozens or more different stocks, bonds, or whatever it specializes in. That way, if some of the holdings aren't performing well, they may be offset by others that are doing better. In fact, some funds balance stocks and bonds to provide diversification in different categories of investments as well as within each of those categories.

Because a fund pools investors' money to make its purchases, it can generally achieve a breadth of diversification that no individual can. However, you do pay annual asset-based fees on all funds you own.

You might also consider exchange traded funds (ETFs), which allow you to buy shares of a portfolio of stocks — each ETF typically linked to a specific market index. ETFs trade like stocks and, while you buy them through a brokerage account, are usually less costly than mutual funds as well as providing more trading flexibility.

ONE MORE THING TO REMEMBER
Diversification is essential for retirement investments. It's especially important if a stock purchase plan is part of your pension plan, because your long-term payout will depend on how well your employer's stock does. You'll want to balance your dependence on the company's financial health with different investments in your own accounts, including your 401(k) or similar plan.

Diversification is especially important if your employer's stock is cyclical, which means its price is strongly influenced by changing economic conditions. Hotel stocks, for example, tend to be depressed in a slow economy because people travel less. If that's the case, you may not want to put too much money in to other stocks that behave the same way.

To extend the idea one step further, you may want to think twice about building a portfolio full of stocks and bonds in companies that are in the same business your employer is in. If the pharmaceutical business declines, for example, and all you own are drug company stocks, you'll really need an aspirin.

DIVERSIFICATION FOR THE LONG HAUL
Diversification isn't the same as buying randomly. If anything, it's the opposite, because it means buying according to your strategic plan to get the right mix of investments. But there's nothing wrong with achieving diversification gradually. If you decide to expand your equity holdings because the stock market seems poised for steady growth, you can do it and think about adding to your bond portfolio in the months ahead. The right level of diversification for you at a given time depends on a variety of factors, including where you are financially, what your goals are, and what the market is doing.