The concept of diversification is vital to investors: Don't put all your eggs in one basket so they won't all get smashed if you trip and fall. It's better to spread your wealth over a broad financial spectrum of investments, but avoiding pitfalls isn't as intuitive as it may seem. Diversification neither assures a profit nor guarantees against loss in a declining market. This is especially important to remember when stocks are soaring and portfolios can get overloaded with stocks and human nature is to get greedy and overly optimistic about a continuation of the current trend.

Retirement investors sometimes think broadening asset allocation is as easy as plunking 401(k) contributions into a fund investing in the Standard & Poor 500, which is called a "broad market index." But 500 stocks is not a diversified portfolio. It diversifies exposure in a single asset class - namely, large U.S. companies with a market capitalization of more than $10 billion. That's not a broadly diversified portfolio.