Believe it or not, portfolio diversification has worked

— -- Diversification has turned into a dirty word with many investors saving for retirement.

It looks great on paper. Diversification is the hailed financial theory that says investors can reduce the ups and downs of their portfolio by sprinkling money all over the place in different types of investments, rather than plunking down everything on just household-name U.S. stocks.

Yet, in most cases, diversification hasn't completely shielded investors from the market's intense pain over the past decade. For instance, adding foreign stocks is considered a key part of diversification. Yet, investors have watched in horror as shares of foreign stocks — which tanked along with the U.S. market in 2008 — have continued to suffer amid the European debt crisis.

Investors who take a closer look, though, can see that diversification has done what it's supposed to do. And for investors looking for a prudent way to gear up for the stretch goal of saving for retirement, diversification can still be a big key to success.

"Diversification is like a free lunch, or at least a free hors d'oeuvre," says Ian Ayres, professor of law at Yale University who has studied diversification. "You want to take advantage of it."

Workers looking to put diversification to work for them as they save for retirement must understand:

Diversification did work, even during the downturn.

There's no question it's been a disappointing decade for stock investors. The Standard & Poor's 500 index returned just 1.4% a year on average between January 1, 2001 and Nov.30, 2011, says money management firm

But investors who created a diversified portfolio, containing among other things a 40% weighting in bonds, saw an average annual return of 5.7% during that same period, IFA says. While some asset classes that diversified investors bought have suffered, as a whole, largely due to bonds' strong performance, diversification has evened out the dips.

While investors might be disappointed with a diversified portfolio's returns, they'd be distraught over the return had they not diversified, says Stuart Ritter of T. Rowe Price.

Had investors bought the best stocks of 2007 and held them in the 2008 market downturn, they would be down more than 60%, he says. An investment in just the Standard & Poor's 500 was down a painful, but more palatable, 37% in 2008, he says.

What diversification really is.

Diversification aims to reduce risks of specific types of investments. For instance, if one company in the S&P 500 has a bad quarter, if you're diversified, that won't derail your retirement plan.

But even a diversified stock portfolio can't eliminate what's called "systemic" risk, or the danger that the entire financial system will come under strain, says Weston Wellington at Dimensional Fund Advisors. During a crisis, risk of the entire financial system short-circuiting can hurt even a diversified portfolio. Stated another way: Investors need to understand what diversification is protecting them from, says Dimensional's Gerard O'Reilly. For instance, drivers know car insurance will protect them from financial losses in an auto accident but not if they get sick, he says. Similarly, diversification is a great tool to protect against risks of problems at a particular company or industry, but not if the entire financial system comes under strain.

Diversification can get more powerful over time.

Many investors preparing for retirement miss out on the full value of diversification by starting too late. A majority of investors save very little when they're starting their careers, which is exactly when diversification can be most powerful because of the long amount of time before money is needed, says Yale's Ayres. And these same investors pile into stocks in the 10 years before retirement, subjecting themselves to the great risk stocks might have a disappointing decade, such as was the case in the 2000s.

But diversification can be honed to make it work for investors gearing up for retirement. By adding to their holdings and taking advantage of lower prices during corrections, Ritter says, investors get the benefit of diversification over time. "We're trying to get people over the emotions of the short term," he says. It's a key point now because while stocks have lost ground during 10-year periods before, as happened the past 10 years, they've never posted losses over a 15-year period, he says. For that reason, investors saving for retirement must remember a lousy market can be a benefit as shares are accumulated at lower prices, says Scott Tiras, private wealth adviser for Ameriprise in Houston.

A diversification plan must change over time.

Investors shouldn't get wedded to their current diversification plan. As retirement nears, it's important to shift money into asset classes that are less risky, says John Sweeney of Fidelity Investments. Investors can do this automatically by investing in "target date" funds, which adjust the weighting toward stocks, bonds and cash as retirement nears.

Another aspect of having a flexible diversification strategy is often overlooked. Investors need to update their market expectations as time goes on, he says. For instance, investors must incorporate the financial crisis and the last bear market in market forecasts. And that, for some investors, might mean dialing back a bit on how aggressive they're willing to be given that the dismal prior decade is "now part of our reality," he says.

The power of diversification over time is so strong that some very aggressive investors, early in their careers, might even consider using borrowed money to increase the size of their diversified portfolios, Yale's Ayres says. These portfolios, spread among a broad basket of stocks and bonds, would give young investors a full 25 to 30 years with more money in the market, helping to boost long-term returns, he says. Investors, though, need to be aware that this strategy works best only when investing in a broad array of investments, and the level of borrowed money being used must be dialed back as the investor nears retirement, he says.

There's some debate over whether the concept of diversification needs to be broadened. Some advisers, such as Ameriprise's Tiras, are adding alternative investments such as gold and other commodities to portfolios. But Dimensional's Wellington thinks adding gold, which is a very risky asset, adds little value over time.

"Gold is so volatile, it's not a hedge against anything," O'Reilly agrees. Investors who buy gold, especially gold that's not in physical form, thinking that it will somehow diversify their portfolio in case of an epic failure of the financial system are deluding themselves, he says.

Investors in most cases are best served just keeping diversification simple, says Annamaria Lusardi, professor of economics and accountancy at George Washington School of Business. Blend stocks and bonds, typically holding the percentage of your portfolio in stocks equal to 100 minus your age, is a common rule of thumb. "Stocks and bonds. It's enough," she says. "The alternative will be you spending a lot of time with finance."

Three sample asset allocations

1)A simple portfolio for a 30 year-old, according to T. Rowe Price:

• 90% stocks

• 10% bonds

2)A simple portfolio for a 50-year old, according to T. Rowe Price:

• 79% stocks

• 21% bonds

3)An advanced portfolio for an extremely risk-tolerant person, according to Index Fund Advisors:

• 20% U.S. small company stock

• 20% U.S. small value company stock

• 12% U.S. large company stock

• 12% U.S. large value company stock

• 6% International value stocks

• 6% International small stocks

• 6% International small value stocks

• 5% Real Estate

• 5% Emerging markets small cap stocks

• 4% Emerging markets stocks

• 4% Emerging markets value stocks

Previous stories in USA TODAY's Retirement Review series:

Retirement rules of thumb don't always apply

Make your savings last as long as you do

Time spent selecting a financial adviser can pay off