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While most people know that they should diversify their investments, the question of how to properly diversify is often a difficult one to answer. Since each person has a different risk tolerance and is at a different point in his life, each person's level of diversification varies. Almost everybody knows that they should diversify between stocks and bonds, but how do you know how much to invest in each? Also, once you decide your stock vs. bond allocation, how do you choose which stocks and bonds to invest in?
Step 1:

First, decide how much money you have to invest. Then decide how much you want to invest in stocks, and how much in bonds. A rule of thumb when diversifying is to use your age as the percentage of bonds in your portfolio. This means that if you are 30 years old, you should keep approximately 30% of your portfolio in bonds, and 70% in stocks. Bear in mind that this is only a rough guideline, and you can change it to reflect your risk tolerance. You may want to hold more stocks if you tend to be more risky, and more bonds if you tend to be less risky. Deciding on your risk tolerance before investing will make it easier to make the stock vs. bond allocation decision.

Step 2:

Now that you know how much you want to invest specifically in stocks, you must know how to diversify your stock holdings. There are many different types of stocks that you can invest in. For example, some of the types of stocks that you can invest in include large-cap, mid-cap, small-cap, growth, value, global, and foreign stocks. There are many options to choose from, but you should try to talk to a financial advisor to help assess your risk tolerance. If you are younger and tend to be more risky, you may want to invest in small-cap growth stocks. However, if you are less risky and older, you may want to invest in large-cap value stocks that pay a nice dividend. However, remember that your choices in stocks need to balance out your bond holdings.

Step 3:

Now that you know how much you want to invest in bonds, you must know how to diversify your bond holdings. There are thousands of bond issues out there to diversify your bonds. One of the easiest ways to reduce the risk of your bonds is to hold bonds with different maturity dates. You would not want all of your bonds to mature in the same year because your income stream would immediately dry up. Make sure that the maturity dates of your bonds are spread out to ensure a steady stream of income that won't suddenly disappear. Another way to diversify your bond holdings is to invest in different types of bonds and bonds with different credit ratings. For example, you can buy municipal bonds, federal bonds, and corporate bonds. Remember, that the most secure bond rating is AAA, but you may not want to hold all AAA-rated bonds. Bonds with lower credit grades normally pay higher yields, so make sure that when choosing bonds, you choose different maturity dates and different credit ratings according to your risk tolerance.

As you can see, diversifying your portfolio between stocks and bonds can be rather simple. By diversifying properly, you can reduce risk and potentially receive higher returns than with a non-diversified portfolio. Remember, if you do not feel comfortable making these investment decisions by yourself, you can always seek the advice of a qualified financial advisor.

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