The Right Way to Diversify

"Don't put all your eggs in one basket" is an oft-chanted mantra among investment advisers. Many investors equate diversification with portfolio allocation, defined as spreading assets among generally uncorrelated vehicles such as stocks, bonds and cash.

But what this really boils down to is a method that tries to guarantee mediocre returns by watering down the best performers with losers to protect against the "risky" side of your investments.

The trend-follower's view of diversification is completely different. While portfolio allocation is a way to hedge your bets and minimize your losses, trend-following diversification is a way to boost your investments' performance.

Looking through the trend-following lens, diversification means including a variety of stocks and indices in your portfolio to reduce exposure to any individual stock. After all, if stocks traditionally bring in the best return, isn't that where you want your money?

Yes, it sounds risky. But not if you have a system that removes the risk when the market tanks. This is a key tenet of the trend-following risk-management discipline and should be part of every investor's strategy.

By following broad market trends, investors are able to maximize returns in both up or down markets by stepping aside, at the least -- or by shorting the market at best -- during down times. In doing so, you are able to manage your downside risk.