Fix Your Mix: Diversification Made Simple, Part 2

If you've reached this stage on the road to wealth, you've presumably taken the first, crucial step toward diversifying your portfolio: deciding how much of your portfolio to allocate to stocks and how much to bonds.

Now it's time to really refine your portfolio, both to make sure you are broadly diversified and perhaps to reach for a higher return. Here's how.

1. Go beyond blue chips. Many investors will choose to purchase stocks through a mutual fund that holds mostly large company stocks, or one that tracks an index like the S&P 500, a list of the 500 most valuable public corporations.

That generally makes sense: Such blue chip stocks represent about 75% of the value of the U.S. market. But it leaves out another 25% that you don't want to miss, because in many years shares of small- and mid-size companies outperform the big ones.

The Money 50 list of recommended funds includes the dedicated small- and mid-size picksiShares Core S&P Mid-Cap ETF and iShares Core S&P Small Cap ETF. Or you can simplify your portfolio my choosing a core holding that includes the full spectrum of U.S. stocks, such as a "total stock market" index fund.

2. Consider a tilt. A large body of research has shown that it's very difficult for stock pickers to outperform the market. (In other words, you are usually just better off buying and holding an index fund.) But some of the same researchers have identified a few patterns in historical stock returns that might help you carve out extra gains over the long run. Both small-company and "value" stocks -- that is, those that trade at low prices relative to their earnings or business value -- seem to offer investors an edge.

Small-cap stocks have bested blue chips by an annualized two percentage points since 1927, according to Morningstar data. About the same is true of large-company value shares over pricier large "growth" stocks. The big winners? Stocks that are both small and cheap.

It's important to understand that this extra return isn't without a downside: Smaller companies provide a high average return because they are riskier investments. Likewise, value stocks may be priced low because the market sees trouble ahead for the company. And portfolios tilted toward small and value sometimes underperform the market for years -- so this is a strategy that requires patience.

You can tilt your portfolio by beefing up your stake in a small-cap fund or adding a value-focused fund to your core holdings.

3. Don't forget your passport. The U.S. market represents only about a third of the world's equities, by market value. That doesn't mean you should own mostly foreign companies -- the rest of the world's markets include some very risky places to invest -- but many advisers recommend keeping about 30% of your stock portfolio in an international mutual fund or ETF.

One big reason is diversification: Foreign markets don't move in step with U.S. markets. By further spreading out your risks, you may be able to lower your volatility without sacrificing return.

Emerging markets funds, which invest in places like China and Latin America, frequently sport impressively high returns in good years, but often at the cost of extreme volatility. If you want to reach for those extra gains, go with a fund that diversifies broadly across many different emerging markets. Or simply hold a foreign fund that includes emerging markets as a part of its strategy.

4. Diversify your bonds, too. Keep money you expect to be tapping relatively soon in bonds with short maturities, or in a bond fund with a short duration. (Duration is a measure of how a bond will react to a change in interest rates -- roughly, a fund with a duration of two years will lose 2% for each 1% rise in interest rates.)

For longer-term holdings, look for a fund with an intermediate portfolio duration, which will allow you to take advantage of higher yields. You can also spread your bets among different kinds of bond issuers -- many general bond funds hold both corporate bonds and U.S. Treasuries. Foreign bonds offer diversification benefits similar to foreign stocks.

You can also diversify the risk of inflation. A Treasury Inflation Protected Security, or TIPS, bond delivers a lower yield, but one that is guaranteed not to be eroded by inflation. You can buy individual TIPS from Treasurydirect.gov, or hold them through a mutual fund that specializes in inflation-protected bonds.

For more from Road to Wealth on asset allocation, see part one.