Diversification and allocation: building a sturdy portfolio

If you remember only one thing about building a portfolio, make it this: what you own matters less than how it fits together. A collection of individually great investments can still make a fragile portfolio if they all rise and fall at the same time.

Diversification: never bet the ship on one engine

Diversification means spreading your money so that no single company, industry or country can sink you. Picture two investors with $10,000 each. One puts everything into a single stock. The other owns a fund of hundreds of companies in which that stock is 1% of the total. If the stock drops 80%, the first investor loses $8,000. The second loses about $80 on that holding.

Real diversification works on several levels:

• Across companies: hundreds or thousands, not five or ten.
• Across sectors: each sector, such as technology, energy or health care, booms and busts on its own schedule.
• Across company sizes: giant companies and small-cap companies do not always move together.
• Across countries: U.S. companies make up a large share, but not all, of the world's stock market value.
• Across asset classes: stocks, bonds and cash behave differently in different conditions.

Diversification is often called the closest thing investing has to a free lunch, because it can reduce risk without necessarily lowering expected return. It has limits: in a severe crisis many assets fall together, and owning several funds that hold the same stocks is not real diversification.

Asset allocation: your biggest decision

Asset allocation is your mix of broad asset classes, mainly stocks, bonds and cash. Stocks are the growth engine, bonds are the shock absorbers and cash is the fuel reserve. The mix you choose largely sets both your expected long-run return and how rough the ride feels.

These are illustrations, not prescriptions. Your mix should reflect your time horizon, your risk tolerance and your goals. Many investors shift gradually toward bonds as a goal approaches. Target-date funds do this automatically, holding a diversified mix that grows more conservative as the target year nears.

Rebalancing: keep the mix on course

Markets move, so your mix drifts. Start with $10,000 at 60/40: $6,000 in stocks and $4,000 in bonds. If stocks rise 30% while bonds stay flat, you hold $7,800 in stocks and $4,000 in bonds. Stocks are now 66% of the portfolio, so you are taking more risk than you chose.

Rebalancing brings it back: sell about $720 of stocks and buy bonds to return to 60/40. Trimming what is winning feels backward, but it is a built-in way to sell high and buy low. Many people rebalance once a year, or whenever an asset class drifts more than about five percentage points from its target. Sending new contributions to whatever is underweight can do the job with fewer sales and less tax.

Simple can be enough

A diversified portfolio does not need to be complicated. Some investors use just two or three broad index funds, for example a U.S. stock fund, an international stock fund and a bond fund, and rebalance occasionally. See how that works in Index funds and ETFs, then learn how to invest steadily in Dollar-cost averaging.