One of your most important investment decision is how much of your portfolio is allocated to stock-type investments and how much to fixed income securities like bonds. Diversifying by shifting some money from stocks into bonds has the effect of lowering overall returns somewhat, but it also greatly reduces the volatility of your portfolio.

While this stock/bond allocation decision is the most important diversification issue, it is by no means the only one you must address. No, after deciding how much of your portfolio is appropriate to allocate to stocks in general, it is important to then take the next step and diversify between different types of stocks.

To assist in this process, Sound Mind Investing divides the U.S. stock market into four parts, or “risk categories”.  (A fifth stock risk category includes mutual funds that invest primarily in foreign companies.) In doing this, we make two distinctions. The first distinction is when we separate funds that invest primarily in large companies from those that invest in smaller companies. Larger companies are slower growing, but are usually safer during recessions. Smaller companies have greater growth potential, but it's accompanied by greater risk.

The second distinction we make is based on a fund's "style" or "discipline." This refers to what kind of stocks that particular fund normally likes to buy. Funds typically fall into one of two major groups. The "value" group emphasizes how much you are getting for your investment dollar, meaning the price paid for each stock is very important. The "growth" group focuses instead on the growth potential of a company. If it has great future prospects, a growth fund may buy its stock regardless of whether it trades at an expensive price.