Diversifying your investment portfolio means putting together a mix of stocks, bonds and other investments with your financial goals, time horizon and risk tolerance in mind. Your mix is called your asset allocation. The idea behind diversification is that, overall, owning different kinds of investments should earn you higher returns with less risk than holding any individual investment.
Establishing the mix, or asset allocation, right for you is one of the most important factors in determining long-term investing success. But then you must do the ongoing maintenance necessary to produce your desired results and control your risk. This occurs through a process called rebalancing, which restores your portfolio to its original asset allocation and risk profile.
Each investment in your portfolio will increase or decrease in value at varying rates, changing your asset allocation. Asset classes, or groupings of similar types of investments, will have months, years or even decades when they outperform or underperform other asset classes. Examples of major asset classes are stocks or equities, bonds or fixed-income investments, and real estate or other tangible assets. Each major asset class can be further categorized into greater detail. For example, equities can be broken into large cap, small cap, U.S. (domestic), international, growth, value and other buckets.
Think about it like preparing a balanced meal to include a protein, vegetables, fruit and grains. Specifically, you could have chicken, asparagus, watermelon and whole wheat rolls. Or you may want BBQ ribs, french fries, roasted peppers, cantaloupe and chocolate cake.
You can rebalance in a couple ways. You can get back to your desired asset allocation when you add or withdraw funds. A way to generate cash is to let dividends pay out instead of automatically reinvesting. Another method is to sell investments in an asset class that has increased in value beyond its set percentage and purchase investments in asset classes that have declined in value.