The Big Picture - Portfolio Diversification

How does one go about diversifying one's portfolio?

Is it as simple as buying a small percentage of total international index stock fund? That's a great start; an evaluation of that index might reveal that you're getting very few small cap stocks or little to no exposure to volatile emerging market stocks.

I've found an article by Paul Merriman that does a great job of showing you why you should diversify and exactly how to go about it. He starts with an S&P 500 index and adds different pieces of the market one at a time. As he goes along, he shows you the affect on performance (it usually goes up) and volatility (it usually decreases). This is a perfect way to show how diversification increases your portfolio performance over time while decreasing risk- the chance that your investments will do terribly over some period of time.

What's bad about this article:
1. It's very in-depth and can be a bit dry.

What's good about this article:
1. It explains why you diversify.
2. It starts with a single investment - the S&P 500 - and walks you step by step through a complete portfolio diversification.
3. It goes back to 1970, so it includes a long bear market. Many past-performance type analyses go back to 1980 or so; therefore they include 2 long bull markets but no long bear markets.

Merriman gives specific examples of portfolios, which I'll look at in the next post.