Beginner's Guide to Diversification

Risk and return work together; the risk you are willing to take affects the returns you can earn in the stock market. The higher the risk, the higher the potential reward. As you walk through the jungle, you'll also hear about volatility , which is how risk is often measured. Volatility is how much stocks go up and down. Some stocks are very volatile, while some stocks are more stable and consistent. For example, a volatile stock that you purchase at $10 may go up to $20 in a year but in the meantime dip down to $5. A stable stock you purchase at $10 may go up to only $13 in a year, but it will get there steadily by going from $10 to $11 to $12 and so on. Which one would you like to live with?

Why is it so important to think about the risk you're willing to take before you invest? Because you can't decide on asset allocation , or how much to invest in each of the assets in your portfolio , without knowing the risk you're comfortable taking. John failed because he didn't take the time to do that. As a result, he gave up on the stock market before he really had the time to become successful.

Beginning investors often make the mistake of overloading (see overweighted ), either putting too much into one stock or, as John did, putting everything into the same sector over and over again. John could have avoided his fall by investing in several different sectors, and in several different companies. Why is this so important? Because if you have good diversification, you won't go hungry if one of the pieces (of your investing pie) falls apart!

Don't get dazzled, like John, by looking at just the return side of the equation. Think about how much risk you can take before you start to get uncomfortable.

Coming up around the next bend: We'll help you look at how much risk you want to take for the returns you want to earn in the market.

You're ready to go deeper into the jungle -- getting a grip on how much risk you want to handle.

Next: Establishing Financial Goals and Discovering Your "Risk Zone." To get a head start, click here.