Diversification

Each asset class is made up of subclasses, or subcategories, which expose investors to different levels of risk and provide their strongest returns at different times in an economic cycle. For example, some stocks, such as blue chips — issued by large, well-regarded companies — are considered less risky than aggressive growth stocks — issued by new companies in new fields. Sometimes blue chips provide the best return, and other times aggressive growth stocks do.

The point is that no single subclass consistently produces the best return year after year. And there's no way to predict the pattern of performance. But you can be confident that subclasses will have their ups and downs just as asset classes do.

Create a mix

While risk can't be completely eliminated, it can be controlled. One way to manage some of the risks you face by not knowing which subclasses will be strong or weak at any specific time is to diversify your portfolio, or your list of investment holdings. To diversify means to choose investments in several different sectors, issued by companies of different sizes, and in the cases of bonds with different terms and issuers, within an asset class, rather than concentrating your money in just one or two areas.

Diversification is the investment equivalent of the old saying: "Don't put all your eggs in one basket." It enables you to:

1. Take maximum advantage of market conditions and changes in the economy.
2. Protect yourself against economic and industry downturns.

How do you do it?

When diversifying your portfolio, it's just as important to understand the investments you already have as well as those you're considering adding. Using a simplified example, say your portfolio consisted entirely of stock in Company A — perhaps the company you work for. If this were the case, your portfolio wouldn't be diversified, and if Company A were to fail, your losses could be major.

But if you were to buy shares in companies B, M and Z, in addition to A, your portfolio would be more diversified — provided that B, M and Z were all in different sectors of the economy and had different market capitalizations. While that may mean you limit your gains, it also means you position yourself to limit your losses, since different types of stocks are not as likely to lose value at the same rate or at the same time.