The stock market has been charging bullishly upward for years, so it’s no surprise that about half the respondents to a recent Wells Fargo/Gallup poll were concerned that a major correction is due. What is surprising is that a good 72% of the respondents to the poll had made little or no effort to diversify their portfolios.

Diversification is a simple way to protect your investments during market corrections, and failing to do so can lead to disaster.

What is diversification?

In investing terms, diversification means spreading your money across a wide range of different investments to make a well-rounded portfolio.

The benefit of diversification is that no matter how the stock market or the economy is doing, at least some of your investments will be thriving — and if a single investment tanks, it won’t drag your entire portfolio down with it.

Diversification lowers your risk and also gives you more options in the event you need to sell off some investments to generate cash.

Diversifying between asset classes

Different types of investments (known as “asset classes” in investor-speak) tend to react differently to the same conditions. For example, take stocks and bonds. When everything’s going smoothly, both types of investments tend to prosper. However, when the economy starts to shift in one direction or another, stocks and bonds often react in opposite ways.

When the economy is hurtling along, the Fed often tries to curb the rate of inflation by raising interest rates. At this point, stocks will continue to climb, but the value of existing bonds will fall, because new bonds — issued at the new, higher interest rate — will have better returns than the old ones. And why would someone want to buy your existing bonds when they could get the same bonds with a higher return somewhere else?

On the other hand, when the economy slows down and starts looking like it’s on the brink of a recession, the Fed will generally try to spur business by lowering interest rates, which makes it easier for companies to borrow money and therefore to start growing and expanding again.

The kind of economic behavior that will generate this reaction also tends to drag down stock prices, as stocks are based on businesses. The drop in stock prices will inspire many investors to sell out of stocks and buy bonds instead, driving up bond values. And when the Fed does lower interest rates, existing bonds become even more valuable, as they’re still paying interest at the former rate.

Stocks and bonds aren’t the only assets available, though a savvy investor can do an excellent job of diversifying with just those two types of investments. If you’d like to range further afield, you could also purchase real estate (in the form of actual property or shares in a real estate investment trust), cash or cash equivalents such as CDs, or commodities such as gold.

Diversifying within an asset class

Buying investments from two or more different asset classes is a great way to start diversifying, but it’s not enough by itself. If you buy, say, both stocks and bonds issued by the same company, then you own two different types of investments, but you’re hardly diversified. If that company were to go out of business, your entire portfolio could go poof.

That’s why it’s important to buy widely differing investments in each asset class. The simplest way to diversify your stock and bond holdings is to buy shares of stock and bond index funds.

Many of these index funds are already quite diversified for you. For stocks, an S&P 500 index fund is a great way to start, because it will automatically invest you in hundreds of large, established companies. If you want to be even more diversified, you can go for a total stock market fund, which buys shares of everything on the entire U.S. market.

Bond funds allow you to invest in bonds that are grouped by term (short-term, intermediate, or long-term), type (Federal, corporate, municipal), and other qualities. As with stock funds, you can also choose an extremely broad bond index fund that will pick bonds from each and every one of these categories.

Diversifying geographically

Another excellent way to diversify is to purchase some foreign investments. After all, a market crash here in the U.S. may not affect China’s stock market at all.

Some wide-ranging stock and bond funds include a few foreign holdings; you can also choose to purchase shares of one domestic index fund and one foreign index fund. If you choose the latter approach, be careful to select a foreign fund that includes investments from more than one country.

Once you’ve diversified your portfolio, you’ll have a much better chance of riding out any economic turmoil that occurs in the future. Market downturns are inevitable, but while certain investments are sinking, others will help to keep your portfolio afloat.

— Wendy Connick

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Source: The Motley Fool