Headlines about stock market fluctuations weighed on LaTasha Christian, a senior accountant at a nonprofit in Chicago, when she inherited more than $25,000 last year. "I wanted to invest,†says Christian, "but I was concerned about losing money in stocks.†Christian went to Eric Grant for help. A managing partner at Polaris, a financial planning and wealth management firm, Grant says an investor's risk tolerance will help determine a satisfactory mix of holdings and asset allocation targets. "I usually give my clients a risk tolerance evaluation before I offer investment advice.†The results surprised Christian who, though only 34, considered herself "very conservative, but the questionnaire showed that I was actually only moderately conservative.†Using the results as a guide, Grant suggested a mixed portfolio of stocks with many more bonds. Finding a stocks—bonds ratio is just the beginning of putting together a diversified portfolio. There are many types of stocks and bonds; mixing their subcategories can provide a smoother ride than investing in, for instance, all large-company stocks, or all long-term bonds. The goal of diversification is to reduce risk, says Eric McKissack, CEO of Channing Capital Management, an investment management firm in Chicago. Volatility is limited, since not all asset classes, industries, or individual companies move up and down in value at the same time or at the same rate. Though diversification can protect an investor from big losses and allow for more consistent performance in a wide range of economic conditions, it can also lower average annual returns and long-term returns. Anything that reduces risk usually also reduces return, says McKissack. (Continued on next page) Spreading the Wealth Generally, the spectrum of diversified assets includes cash, domestic and international stocks and bonds, real estate, and alternative investments such as commodities, private equity, and hedge funds. Assets that may be risky by themselves can lower portfolio risk when used as part of a broadly diversified portfolio, "as long as you make sure you diversify by holding non-correlated assets,†McKissack says–that is, asset classes that don't move in the same direction at the same time. In a year when a supposedly safe asset such as long-term government bonds loses heavily, riskier assets, such as emerging market stocks, tech stocks, and junk bonds, can excel and help to mitigate the loss. For instance, after the 2008 financial crisis, economies in countries like China, India, and Brazil looked very attractive. Emerging market funds grew in total assets under management on average 39% per year from 2001 to 2011, according to the research firm Morningstar. Despite some losses during this period, at the end of 2010 there was $22 billion invested in emerging market mutual funds. Had you invested $10,000 in, for example, the Forward Emerging Markets Institutional Fund from 2002 to 2012, your money would have grown to more than $35,000. On the flip side, investors who loaded up on bank stocks saw an average return in 2008 of -30.4%. "Diversification should include exposure to large-cap, small-cap, value stocks, growth stocks, etc.,†says Grant, "but also a mix of individual companies or mutual funds in a variety of industries, like financial services, consumer products, pharmaceuticals, energy, etc.†(Continued on next page) Diversification must be periodic, since a portfolio that's diversified now might not be as well-balanced six months or a year from now. It's critical to guard against unintentionally becoming concentrated in one area because of investment winners and losers, saysMcKissack. As some assets do well and others hold their value or do poorly, your portfolio's diversification will change and your asset allocation will go off-target. Let's say your target allocation is 35% in large-cap stocks. A few months of blue-chip leadership could push your holdings up to 40% and depress other asset classes. "Periodically rebalancing your portfolio will keep your diversification current and in line with your overall plan,†says McKissack. Rebalancing involves selling and buying portions of your portfolio to make sure that each asset class gets back on the right track. That is, sell your winners and put the proceeds into asset classes that are below their desired level. How often should investors rebalance portfolios? "For LaTasha and other clients, we usually rebalance quarterly,†says Grant. "Studies show that the selection of individual securities is secondary to the way you allocate your investment in stocks, bonds, and cash. The allocations will be the principal determinant of your investment returns.†(Continued on next page) The investments in Christian's portfolio are made mostly through Russell mutual funds (a core fund family that holds both growth and value stocks.) In addition, her portfolio is diversified through real estate investment trusts, or REITS. Real estate has some of the characteristics of stocks (potential upside) and some of the characteristics of bonds (relatively high yields) and often acts as a non-correlating asset because gains and losses tend to be unrelated to moves in stocks or bonds. Christian is happy with her portfolio's performance. "I did really well,†she says, "so I became a little more aggressive.†Grant recently retested her and found that she now has a "balanced†risk tolerance. As a result, "We have reset her asset targets and moved her portfolio to more stocks and fewer bonds.â€