In these blogs, I talk off and on about the importance of not having all of your investment eggs in one basket. Too many investors, unfortunately, put all of their money into last year’s highest performer and cross their fingers. That's a losing strategy, and if you don't believe me, ask an Enron investor.

What such investors really need is a tried and true technique for investing successfully—diversification. Doing so is one of the best ways to protect your investment portfolio from the pendulum swings of the economy and the markets. Simply defined, diversification has you divide your investments across different types of assets. Since a separate account portfolio may invest in different securities, a decline in the value of one security may be offset by the rise in the value of another.

While there have been hundreds of books written on the right way to diversify a portfolio, no one of them can possibly provide you with a perfect understanding of what it takes. What I can try to do here is educate you on the basics, including how diversification works and  why it’s important.

Some background first. Wall Street pundits say they divide the history of investing in the United States into two periods: before and after 1952. In that year, University of Chicago economic student Harry Markowitz published his doctoral thesis – a thesis that would make up the foundation for his breakthrough treatise on investing called Modern Portfolio Theory. Markowtiz’ paper caused such a stir and impacted so many investors that he won a Nobel Prize in economics in 1990.

What is modern portfolio theory? In Markowitz’ view, ground zero for investors is avoiding risk at all costs.  Markowitz defines risk as a "standard deviation" of expected returns.

Loosely translated, instead of considering risk on a single security level, Markowitz emphasizes measuring the risk of an entire portfolio. When considering a security for your portfolio, don't base your decision on the amount of risk that carries with it. Instead, consider how that security contributes to the overall risk of your portfolio.

Markowitz then considers how all the investments in a portfolio can be expected to move together in price under the same circumstances. This is called "correlation," and it measures how much you can expect different securities or asset classes to change in price relative to each other.

For instance, high fuel prices might be good for oil companies, but bad for airlines that need to buy the fuel. As a result, you might expect that the stocks of companies in these two industries would often move in opposite directions. These two industries have a negative (or low) correlation. You'll get better diversification in your portfolio if you own one airline and one oil company, rather than two oil companies.

When you put all this together, it's entirely possible to build a portfolio that has much higher average return than the level of risk it contains. So when you build a diversified portfolio and spread out your investments by asset class, you're really just managing risk and return.

Markowitz has a good point about risk, and its implicit partnership with diversification. After all, everybody’s heard the stories. How the guy at the gym or the lady at the hair salon made a fast killing on last year’s stock picks—or a friend tripled his “investment” one 
morning at the horse track. These are all well and good, but they’re stories about gambling, not investing—risky business that’s fine for entertainment if you can afford it, but not for financial planning. That’s because basing your financial decisions on guesswork not only 
prevents you from growing your money, but also increases your risk for losing it.

Which is one of the many reasons why I like diversification: it’s a technique that, combined with rebalancing, removes the guesswork and emotion from investing.