(LifeWire) - Building a diversified portfolio is one of the most important tasks you must accomplish to successfully invest for retirement.
Diversification involves investing in a broad array of investment types, ranging from conservative bonds and cash to riskier stocks and even commodities. It's crucial because it reduces your risk over time while capturing most of the market's gains.
How Diversification Works
A diverse portfolio ensures that at least some of your investments will be in the market's hottest sectors at any given time -- regardless of what's hot and what's not. And you will never be fully invested in the year's losers.
The result is a portfolio that is rarely the top performer of the year. But it is rarely the biggest loser, either -- a fact that can aid long-term returns while reducing the stomach-churning ups and downs that riskier strategies produce.
Just as an example, consider a fairly typical comparison of portfolio results over the 20 years from 1988 through 2007. A portfolio invested only in growth stocks ranged from a 51% gain in its best year to a 30% loss in its worst, producing an annual average gain of only 8.8%. On the other hand, a relatively conservative portfolio spread diversely among bonds and various types of stocks gained a maximum of 28% but suffered a maximum loss of only 3.5%, posting a 9.65% average annual gain.
Building the Portfolio
It's best for most investors to build portfolios with mutual funds or exchange traded funds, because each fund is, in itself, a collection of many stocks and/or bonds. That averts the risk of investing in only one company.
The stock component should include international as well as US stocks, and large as well as small and medium-size companies. The bond component can generally be small for younger investors, growing larger as retirement age looms.