Greta thought she was following sound financial practice by spreading her investments among more than a dozen mutual funds. She reasoned that her portfolio would be diversified enough to reduce the risk of loss. But when the value of small-company stocks plunged one summer, so did Greta's entire portfolio. It turned out that most of her mutual funds were invested in small-company stocks. The moral of this story: Having a lot of investments does not necessarily make your portfolio diversified. What matters is whether you have a lot of different types of investments.

It is important to look at the structure of your portfolio and the types of companies that are in it. If you are buying all pharmaceutical stocks or all technology stocks or all international stocks—or, for that matter, all stocks—you are not diversifying, no matter how many different company or mutual fund shares you buy.

The purpose of diversification is to protect your overall portfolio from major shocks. Because different types of investments tend to move at different times—one investment may be moving up in value when another is moving down—having a variety of investments lends stability to a portfolio.

Diversification, however, can also reduce your overall return, as does any strategy that reduces risk. (But you already know that, because you read Chapter 2.) Consider this: A portfolio of big-company stocks gained about 10.4 percent annually on average since 1926, whereas a portfolio that ...

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