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Diversification: Never put all your eggs in one basket.

The stock market goes up and it goes down. Some people make money, while others lose money. In order to realize a net gain in the stock market one must follow certain principles. The most important principle being Diversification.

Diversificatio n means "never put all your eggs in one basket". In other words, don't buy one stock and 'hope' it's a winner. Instead, create a diversified portfolio to spread the risk across an assortment of investment vehicles.

For instance, stocks typically fall into different market caps (market capitalizations). We have Large, Mid, and Small Cap stocks. Each market cap carries with it different levels of growth and different levels of risk. Typically, high growth stocks carry a high level of risk. Whereas low growth stocks carry less risk.

Large cap stocks generally carry less risk because they are stable, low growth, and well known companies that have been around forever and they tend to have less volatility than small cap stocks. Small cap stocks are new and up-coming companies, growth oriented, and as such, they have a tendency to experience large fluctuations in price (ie volatility) which increases risk. Then we have Mid cap stocks which fall somewhere in between Large and Small.

Keep in mind, high volatility is not necessarily a bad thing. If you are a trader and are looking for nice profits, then you will want to invest in stocks with large price fluctuations (high volatility), such as small caps, as this will give you more opportunities for buying and selling, which could result in more profit taking.

However, with high volatility comes high risk. Yet, without such risk you will have less profit taking opportunities. Kind of like a catch 22. But if you diversify, you resolve the catch 22.

Diversification can help you spread out your risk. Your portfolio may be grounded on a few Large cap stocks and some mid cap stocks as well. Then add Small Caps to round out your portfolio. The small caps tend to be very growth oriented, yet risky. Large caps are not growth oriented, but very safe. So you can see how diversification among different market caps can lessen you overall risk in the stock market.

Mutual Funds are a good example of an investment vehicle in which the diversification is done for you. A Mutual Fund invests in a wide array of investment vehicles including stocks, bonds, ETFs, and so on. Yet, you can purchase different growth oriented types of mutual funds, similar to different market caps, to add even more diversification.

One other way to reduce risk in the stock market is to purchase put options along with stocks so as to hedge against any losses. As a stock drops in price, the put option rises in price. In essence, the put option is insurance for your stock should the stock price drop.

Diversification is the most important principle to follow when investing your money in the stock market. Always remember, never put all your eggs into one basket because you could lose it all.

Learn more about this author, Kelly Lucas.
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