Lesson 1: The Right Baskets

However, if you understand that investments fall into just five broad categories--and that each can have a role in your portfolio--diversifying your assets wisely becomes a snap. All you need to do is understand the purpose of each investment category, determine how much money you want in each category, or investment "basket," then get familiar with the different options in each basket so you can pick and choose specific securities that make up a well-balanced portfolio.

To help you understand this process, we're presenting this Diversification 101 series. This, Lesson 1, serves as an introduction; subsequent lessons will detail the investment baskets.

The baskets are divided by purpose:

1. Safety. One of the first goals of many investors is to create an emergency fund--money that can be tapped if you ever lose your job, are disabled or face a financial crisis, whether it's uninsured medical expenses or a major car repair.

Because you never know when something like this might happen, the funds you save for emergencies must be easily accessible--what's known on Wall Street as being "liquid." Nor can your principal fluctuate too much in value.

However, investors should realize that money in this category is less invested than it is parked. It's there waiting to handle emergencies and very near-term goals. As a result, safety investments produce rotten returns. In today's market, you can expect to earn from virtually no interest to as much as about 5.5% annually on your money, depending on which type of parking space you choose. Once taxes are factored in, these investments often don't even keep up with the rate of inflation.

So every year a safety-net dollar isn't used, it actually declines in value or buying power. The bottom line: Don't put more money in this category than necessary.

What types of investments are in the safety bucket and how do they work? See Lesson 2 in this series; each part will run Tuesdays here in Wall Street, California.

2. Inflation protection. For some people, the goal of investing is not so much getting ahead as it is not falling behind. Because the cost of goods and services tends to rise--or inflate--they fear they will fall behind if their investments don't rise as quickly as the cost of buying necessary goods and services. Investors who remember the 1970s and early '80s, when inflation ran rampant, are often very concerned about this threat and want to address it head-on with "inflation hedges," such as precious metals or real estate.

However, over time, investments that track inflation merely keep you standing still. And inflation-hedging investments aren't all alike. Some have performed admirably, while others have proved "inefficient," to put it mildly. Which inflation-hedging investments work and how? That will be the subject of Lesson 3.

3. Growth. The main reason that people invest is that there is something they want in the future that they can't afford today--a new car, a new house or a comfortable retirement, for example.

The faster their money grows, the sooner and more effectively they can reach the goal. The hot spot to look for rapid growth of your savings is the stock markets, both domestic and international. Over the long haul, these investments tend to appreciate two to four times faster than investments in any other category. Attractive? Sure. But the money in this basket needs to be long-term, because there are plenty of bumps on the way to wealth. The basics of growth will be explained in Lesson 4.

4. Income. At some point in your life--perhaps after you retire, perhaps sooner--you'll want at least a portion of your investments to generate income. That income can be used to supplement your wages, Social Security or pension, making your life more comfortable. And even before you need income to live on, income-oriented investments can help smooth out the bumps in your portfolio. That's simply because income investments continue to pay steady returns even when the market value of various investments plunges.

The downside: Over the long haul, income investments tend to appreciate about half as fast as growth investments. Worse still, for some Americans the returns on these investments are taxed at a somewhat higher rate. The lowdown on income investments will appear in Lesson 5.

5. Speculation. There is a wide array of speculative investments, ranging from limited partnerships to commodities contracts to "derivative" securities. And there are trading strategies, such as "short selling" and buying "puts" and "calls," that can occasionally supercharge--or decimate--the value of your investment portfolio.

Unless you are both wealthy and highly sophisticated about investing, you should avoid this type of speculation. Not only is there a good chance you will lose all, or a significant part, of your money, but you can sometimes actually lose more than you originally invested.

Nonetheless, some people like to gamble. If you do and you're tempted by complicated and risky strategies--and you've got money to lose--you can gamble with these types of securities. Or you can go to Las Vegas or Atlantic City. Personally, I think gambling at a casino is preferable. You'll still lose money, but people will cater to you and bring you drinks while you do.