One of the most important things you can do to protect your portfolio from volatility and down markets is to diversify. While it won't guarantee you won't have losses, it can help limit them and control day-to-day volatility and risk.

Diversification was put to test during the extreme market volatility in 2008. Our analysis showed that a properly diversified portfolio would have performed better (i.e. lost less) than a non-diversified portfolio. (Read Fidelity Viewpoints article Does Diversification Still Work? to see why.)

Diversification isn't just owning a couple of stocks or a mutual fund. There's more to it than that. Let's walk through two key aspects of it and how to apply them to your portfolio.

1. Create the right investment mix

Having an appropriate mix of investments—also known as asset allocation—can be a critical factor in the overall performance of your portfolio. Asset allocation is straightforward: You spread your money among different types of investments, or asset classes, such as U.S. and international stocks, bonds, and short-term investments. Historically certain types of investments have tended to move in opposite directions, i.e., they are negatively correlated. So if parts of your portfolio are declining, others may be growing. In turn, the overall impact of poor market performance on your portfolio may be dampened.

How you determine your asset allocation largely depends on your comfort with risk and the time frame for your investments. Generally, the younger you are, the more risk you can afford to take with your retirement investments. As you get older and closer to retirement, you may be less interested in growth and more interested in protecting the value of your portfolio. As you reach retirement age this becomes even more important since a large decline in the value of your holdings can affect your retirement lifestyle.

With that in mind, we've put together six target asset mixes—based on risk—ranging from more conservative to most aggressive. You can choose the one that's appropriate for your situation.

2. Diversify within asset classes

The next step is to diversify within the investment categories—U.S. and international stocks, bonds, and short-term investments. For instance, stocks vary according to company size (large cap, mid cap, small cap), style (growth stocks, value stocks), sector (technology, biotech, financials, etc.), and geography (domestic, international developed, international emerging markets). Bonds vary according to their maturity (short-term, intermediate-term, long-term), credit quality (investment grade bonds, high yield bonds), or issuer (government, corporate, municipal bonds).

Asset classes generally don't move in lockstep and performance can vary widely—as the table below shows. No one can predict with certainty which will be the next leader. While it cannot ensure a profit or guarantee against a loss, diversification allows an investor to seek some downside protection and participate in the upside potential of asset class movements.

Are you diversified?

Now that you have a sense of how to diversify, you need to determine if your current portfolio is positioned properly. One way is to compare your holdings to a benchmark. For example, each asset class in our target portfolios (shown above) is tied to a benchmark index that represents a specific asset class:

Our Growth target portfolio (shown above), for instance, is 60% in U.S. stocks as measured by the Dow Jones U.S. Total Stock Market Index; 10% in international stocks measured by the EAFE Index; 25% in bonds tied to the Barclays Bond Index; and 5% in short term represented by the Barclays 30-day Treasury Index.

Each benchmark index is comprised of stocks or bonds spread across different sectors. For example, the Dow Jones U.S. Total Stock Market Index is comprised of stocks in 13 sectors, including hardware (10.1%), health care (12.92%), consumer services (9.11%), financial services (12.73%), industrial materials (11.48%), and energy (11.96%). The percentages represent how much of the index is in the category.

You can compare your current holdings in an asset class to the weightings of its benchmark. For example, if you own Exxon Mobil (XOM), it would be represented in the energy sector in the Wilshire 5000 (.WIL5). Additionally, if you own mutual funds or exchange traded funds (ETFs), you would look at the underlying investments within the fund, and compare those to the benchmark. By comparing your portfolio to a benchmark, you can identify areas in which you are over or underweighted. If you're overweighted in an area, you may want to consider selling some of your investments in order to align more with the benchmark. If you're underweighted, you may want to consider increasing your exposure.

Before investing, consider the funds’ investment objectives, risks, charges and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully.

Asset allocation and diversification do not ensure a profit or guarantee against a loss.

1. Portfolio Review is an educational tool offered for use by Fidelity Brokerage Services LLC, member NYSE, SIPC.

2. Fidelity Freedom Funds are managed by Strategic Advisers, Inc., a subsidiary of FMR LLC. The investment risks of each Fidelity Freedom Fund changes over time as its asset allocation changes. They are subject to the volatility of the financial markets, including equity and fixed income investments in the U.S. and abroad and may be subject to risks associated with investing in high yield, small cap and foreign securities. Principal invested is not guaranteed at any time, including at or after their target dates.

3. Fidelity Portfolio Advisory Service® is a service of Strategic Advisers, Inc., a registered investment adviser and a Fidelity Investments company. This service provides discretionary money management for a fee.

Generally, among asset classes stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate.

The Dow Jones U.S. Total Stock Market Index is an unmanaged float-adjusted market capitalization-weighted index of substantially all equity securities of U.S. headquartered companies with readily available price data.

The Morgan Stanley Capital International Europe, Australasia and Far East (MSCI EAFE) Index is an unmanaged market capitalization-weighted index of equity securities of companies domiciled in various countries. The Index is designed to represent the performance of developed stock markets outside the United States and Canada and excludes certain market segments unavailable to U.S. based investors. The Net version of the MSCI EAFE adjusts for withholding taxes applicable to Massachusetts Business Trusts.

The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar denominated. This index covers the U.S. investment grade fixed rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities.

The Barclays Capital 3-Month U.S. Treasury Bill Index is an unmanaged market value-weighted index of investment grade fixed rate public obligations of the U.S. Treasury with maturities of 3 months, excluding zero coupon strips.