The following is a guest post from Rob Ward. He writes about personal finance every Monday and Thursday at Daily Financial Solutions.

The topic of diversification has been covered before at BFS, but I thought it would be helpful if I went into a little more detail. If you handle your investments on your own or are thinking about doing so I highly recommend the book The Bogleheads’ Guide to Investing. It has great advice for beginners as well as experienced investors. In the chapter about diversification (they refer to it as asset allocation) three questions are offered on how to diversify your investments. They are as follows:

1. What are your goals?

Put another way, what do you want to accomplish with the money you are investing? Are you saving for retirement, a child’s education, or some other large expense? Knowing what you need the money for will help you decide how much you need and how to properly diversify.

2. What is your time frame?

In other words, how much time there is from now until you need the money. The example the book gives is if your daughter will be going to college in three years, investing in stocks would not appropriate. This is due to their tendency to be more risky than other investments. The chance of losing money in that three year time period is too great. You do not want to invest and then find out that you have less money than you started out with. However, the longer your time frame is, the less likely it is that you will actually lose money. According to Bogleheads, from the period of 1935 to 2004, during any 10 year period the worst an “unlucky investor” invested in stocks would have done is lose one percent.

3. What is your risk tolerance?

Essentially, will you be able to handle the potential of losing money? A very important fact to note is that the more risky an investment is, the higher the possible return is. The opposite is also true. CDs and savings accounts are relatively safe investments compared to stocks. However their returns over a period of time will generally be much less. Bogleheads notes that most people have a risk tolerance somewhere in the middle; not completely risk adverse but also not total risk takers.

Another important point they make in regards to risk tolerance is your ability to handle a bear market. Since the last few years we have been in the middle of one this as easy question to answer. Did you sell of your stocks when the market dropped or did you stick with it? Having a plan for diversification can help you stick to your guns and ride out the storms.

The next time you are reviewing your investments, be sure to evaluate your diversification using these questions. It will likely make your investments much better for your specific situation and needs.

Note: there is a fourth question in the book, however I did not think it was as relevant to diversification as the other three questions. If you are wondering however, the question is “What is your personal financial situation?”

Crystal’s Questions:
Do you diversify?  If so, do you take the above questions into account?