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want less risky, low Beta stocks in our portfolio to protect our money when the market is not doing so well. Say we have a stock with a Beta of 0.5 and the market goes down 10%. In this case our stock only loses 5% (0.5 x 10% = 5%).

The purpose of diversification is to find a balance that will provide a moderate level of security for poor market conditions and to provide potential for high gains when the market is flourishing. The higher the risk, the higher the potential return. It is important that any individual investor determine the amount of risk tolerable in your portfolio determined on factors such as age, expenses, financial situation, dependents, etc..

Think of a mutual fund as a portfolio of different stocks that a mutual fund manager has chosen in order to maximize return while minimizing risk depending on the specific funds objectives. This manager buys and sells different amounts of different types of stocks without the investor having to constantly be aware of where the overall market is headed.

Mutual fund managers will charge a fee to the investor in order for providing this service. It is important to research the manager(s) of a fund before investing in order to ensure that the he/she has a credible history.

Keep in mind that we have only considered the stock market. Other investments such as bonds, commodities(gold, silver, etc.), and Treasury Bills have different degrees of risk and potential returns associated with them. These should be used as vehicles for financial growth as well. A truly diversified investor is not limited to the just the stock market, but seeks an overall balance of risk and return consistent with that individuals specific investment strategy.

Learn more about this author, Richard Ruscitto.
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