Unlike asset allocation, which divides your investments up into different investment types, such as stocks, bonds and CDs, diversification is a risk management technique that mixes a variety of investments within a portfolio. For example, if you are investing in stocks you might diversify your portfolio in the following manner: 30 percent technology companies, 50 percent manufacturing companies and 20 percent financial services companies. Another example of a diversified portfolio may include 60 percent blue chip or large, well-established companies and 40 percent aggressive growth stocks or small, newer companies. Diversification is similar to not putting all of your eggs into one basket.
Having a diversified portfolio can help to offset the negative performance of one security over another. In other words, if your blue chip company increases by 15 percent in a month and your foreign security decreases by 8 percent during the same time frame, your portfolio will still have a net increase of 7 percent.
Unlike institutional investors with deep pockets, most individual investors have limited budgets and often cannot afford to fund an adequately diversified portfolio. For starters, the more stocks you have the more brokerage commissions you will have to pay. This is where mutual funds come into play. Buying into a mutual fund can provide investors with an inexpensive means to diversity.