In today's small and networked world, it only makes sense that everything is connected. Nowhere is this idea more important than in the world of investing. The advances in computer technology have allowed investors and traders to trade synchronously across the globe. The negative side effect with these advances is stock markets tend to trade in sync with each other. The only way for a modern investor to protect himself is to use diversification in his investments.

Risk Measurement

One of the top issues on Wall Street in recent history has been how to measure risk. The influx of math PHDs have used enigmatic terms like alpha and beta to describe the risk a stock possesses. These terms don't do much for the average investor who probably stopped taking math in high school. The basic idea to know is whether two stocks trade together or not. In other words, if two stocks go up and down at the same time, owning both of them would not be diversification.

Sector Diversification

One way investors try to protect against risk in the market is by buying stocks of a bunch of different sectors. Let's say someone wants to own five different stocks. To diversify, he may buy an Internet stock, a drug company, a manufacturing stock, an oil company, and a retail stock. Why? Because-different sectors of the economy have strong growth at different times. During one period, technology stocks may be in favor and give investors high returns, while retail stocks are moving flat. Then, the next period, the reverse will be true. While this method won't protect investors from huge downturns, like the one experienced recently, it can allow them to increase profits during the normal business cycle. The goal is then for a portfolio to be balanced out when one sector's value take up too large of a percentage of the total value.

Risk Diversification

While it's true that all diversification involves risk, this type of diversification refers to the risk of individual stocks. Some stocks are inherently more risky than others, such as small caps and penny stocks. These stocks have large price moves and can lose their value much quicker than other, lower risk stocks. Most international companies and industry leader would be considered low-risk. To confirm, the risk involved with these stocks means the risk of an investment losing all of its value. That's the trade off that comes with the high returns of high-risk stocks. While high returns boost portfolios, low-risk stocks are needed to lower the total risk of a portfolio. Investors must diversify with high-risk and low-risk stocks.

Asset Diversification

While asset diversification isn't for most investors, it is probably the most important type of diversification available. Diversifying among different type of stocks can only go so far. The stock market still travels in the same pattern over longer periods of time. The only way to achieve true diversification is to invest in other assets, like bonds, commodities, and real estate. Of all these, bonds and maybe real estate will only be an option to the average investor. These different assets usually trade out of sync with the stock market. When one goes up, the other one goes down. This allows investors to handle downturns in the stock market better than less diversified investors.

Without diversification, the average investor would open themselves to more risk than they need to accept to make a steady return. On Wall Street, it's all about "alpha" or the best profit for an amount of risk. By using diversification, a small amount of risk will give an acceptable return. That is what investing is all about.

Learn more about this author, Kevin Thalersmith.
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