DIVERSIFICATION

By investing in securities from a wide variety of asset classes, you can decrease risk and increase your returns at the same time.  This process is called diversification.

When you diversify, your investment portfolio is less volatile (that is, it changes less), because losses in some investments are offset by gains from others.  Diversification is less risky than putting all your money in one type of investment, because if that type of investment falls, then your entire account value falls correspondingly.  Certain types of investments, such as stocks and bonds, often rise or fall in opposite directions, so investing in both limits your risk.  No single type of investment outperforms all others in every type of economic situation.

There are three ways you can diversify your portfolio.  You can invest in different types of asset classes, such as stocks and bonds.  Or, you can diversify by investing in different types of industries or sectors.  For example, you could spread your stock investments across technology and health care stocks.  Lastly, you can invest in companies of varying sizes, such as small-cap and large-cap stocks.

Another way to decrease your investment risk is to buy or sell securities when they reach a specific price.  In the next tutorial section, let's see how you can do this.