The Right Way to Diversify

Also, I always recommend diversifying away from individual stocks. I think your most sound bet for bringing out the best in this approach is to choose an index-tracking or exchange-traded fund, both of which represent broad baskets of stocks.

In trend-following, we look at two primary ways to diversify:

• By company size: for example, using an S&P 400 mid-cap index fund and a Nasdaq 100 large-cap index fund.
• By geography: This is perhaps the most important diversification strategy. Why? One reason to diversify internationally is to hedge against a further decline in the U.S. dollar.

Another is that world economies have become joined at the hip in the last 20 years, as computers and instant communication put us closer together in real time. However, while world markets are generally correlated and move in sync, they don't all move at the same strength, or amplitude.

In fact, currently, most international markets are outperforming U.S. markets. So, if you are diversified in the Russell 2000 and the Nikkei 225, the Nikkei is outperforming the Russell 2000 index. You may ask, if this is so, why stay in U.S. indices at all -- why not put all your money overseas?

Despite the serious challenges faced by the U.S. (ballooning national debt, escalating budget and trade deficits and two ongoing wars, to name a few), writing off the U.S. stock market is a decidedly shortsighted view. It still makes sense to stay invested in the U.S. market, because it's the most respected, stable and liquid market in the world.