by Wendy Connick

Created on: June 12, 2008

Most money managers will tell you to "pay yourself first" meaning set aside some money from your paycheck to go into a savings or investment account. An excellent vehicle for long-term investment is, of course, the stock market. Over the long haul the US stock market has always gone up, so if you are willing to ride out the occasional nerve-wracking dip, you can end up with quite an impressive return on your original investment. For this type of long-term investment, portfolio diversification is absolutely essential.

Portfolio diversification simply means buying shares of a wide variety of companies spanning multiple markets. It provides you with an insurance policy of sorts against disaster. For example, take the tech market crash of 2000. If you'd had all your money invested in tech stocks at that time as many investors did your portfolio would have lost a tremendous amount of value. Not only that, but quite a few tech companies folded as a result of the crash, which made any stock you might own in them worthless.

On the other hand, if you'd had perhaps a third of your portfolio invested in tech stocks you would have lost plenty of money, but it wouldn't have been quite so bad a hit and if you chose to invest in funds rather than individual tech stocks, you'd have been shielded from the resulting string of bankruptcies.

Index funds provide a great way to diversify your portfolio while limiting your costs. An index fund is a "passively managed" fund, which means that instead of trying to second-guess the market, fund managers try to match it. They'll buy a representative set of shares that matches one of the market indices, for example the S&P 500 index.

There are several advantages to buying an index fund. First, in an actively traded fund you will find yourself paying hefty fees to cover the salaries and other costs of all those busy fund managers. Second, fund managers earn commissions every time they buy new stocks for the fund, so they are motivated to keep turning over fund shares as frequently as possible. This is a problem for you as the shareholder because it opens you up to potentially huge capital gains taxes from all that trading. And third, nearly all actively managed funds under-perform the market. That means they earn you a lower rate of return than those cheap index funds!

Buying shares of an index fund is a great step on the road to diversification, but don't stop there. You can buy shares from different funds that cover multiple indices and limit

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