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The Importance of Diversification

Diversification means building a portfolio that includes securities from different asset classes. Since bonds tend to do well when stocks don't, you could construct a portfolio that includes a certain percentage of stocks and bonds. This helps ensure that at least a portion of your holdings is always doing well.

Another way to diversify is to buy securities in the same asset class that are not affected by the same variables. For instance, entertainment companies, utilities, grocery stores, and airlines are completely different businesses. Depending on the country's economy, one or more of these industries might tend to perform better than the others. If you build a portfolio that includes securities from a number of sectors, chances are that one or more would always be doing better than average.

When you diversify, you try to ensure that at any given time, the value of some of your holdings might be down, and some might be up, but overall you're doing fine. The trick is to find securities that don't have tendencies to increase or decrease in price at the same time.

The trade-off for the balancing of risk and return in a diversified portfolio is that your overall return might be somewhat lower than you could get in an undiversified portfolio. However, along the way, a diversified portfolio will have less volatility, and steadier returns.

Diversification does not eliminate risk, however. It is merely a tool that can reduce the risk you face with your investments.