A closer look at diversification

When you first learned about diversification, you were probably shown a chart about spreading your investments among broad asset classes like stocks and bonds.

But allocating your investments among these top-level asset classes is just the first step. If we drill down within these categories, we can uncover many more ways to diversify a portfolio.

Let's start with stocks, and this includes mutual funds or exchange-traded funds (ETFs) that invest in stocks. One common way to diversify your stock holdings is by company size or market capitalization. The idea is simple: put some money in large companies and some money in mid-sized or small ones.

Within those categories, you can refine even further by investing in a variety of industry sectors such as energy, health care, or technology.

Another way to diversify is by different investing strategies—value stocks vs. growth stocks, for example. Many mutual funds and ETFs include their strategy in their fund name.

By investing in both domestic and foreign stocks or stock funds you can even diversify by geographic location.

It's not just stocks that provide additional diversification opportunities. You can also spread some of your money among different types of bonds. Each type has a different risk profile.

U.S. Treasury bonds are well-known investments and considered very low-risk. Along with mortgage and municipal bonds they may be helpful in offsetting risks in your stock holdings.

At the other end of the spectrum are high-yield corporate bonds, which may not be as effective for offsetting stock risks, but tend to provide higher levels of income.

An asset class known as alternative investments is yet another way to diversify a portfolio. Alternatives include things like real estate, commodities, or even foreign currencies.

As you can see, diversification has many layers. That’s why it’s important to look deeper than just the simple categories of stocks and bonds when you're building a diversified portfolio.