In my recent article, 5 Steps to Protect Your Portfolio, the third step was diversifying your investments to reduce volatility and risk.

Diversification is simply this: “Don’t put all your eggs in one basket.” Create a portfolio that has a variety of noncorrelating assets — i.e., assets whose prices move in opposite directions. That way, if one stock or sector or style of investing underperforms, you have a fighting chance that some of your other assets will rise, ultimately reducing your losses.

Many investors pay no attention to diversification. Instead, they find a sector or industry they like and invest their entire portfolio there. That’s great if all of those stocks keep going up. But the laws of nature — and the stock market — never work that way for long. Consequently, those investors eventually lose their shirts because even the very best sectors don’t rule the market forever.

The bottom line is this: By adequately diversifying your portfolio, you reduce the risk that all of your assets will decrease in value simultaneously.

Having said that, you should know that there is no perfect selection of noncorrelating assets. Like all aspects of investing, the correlation of assets is subject to change over time, through different economic and investment cycles.

As a result, you should think of your portfolio diversification as a moving target. You will need to monitor it regularly so that you can move investments in and out as cycles change. Fortunately, the major economic cycles are generally several years long.

Broadly speaking, there are three major long-term economic cycles:

• Recession ends and expansion begins. The early cycle is when the stock market generally makes the most impressive gains, and more cyclical and high-growth stocks (such as small caps) typically do well.
• The Fed raises interest rates as the economy heats up. About three months prior to this, and continuing for about nine months after, we enter a mid-cycle, when returns continue to be better than average, but not as good as in the early phase. Attractive stocks begin shifting to  cyclical, high-yield investments.
• An expansion ends and a recession begins. For about a six-month period prior to the recession, stocks begin to go flat, then start to decline during the recession, with investors flocking to less economically sensitive, more defensive stocks.

We have had a tremendous run (the early cycle) since March 2009, when the Dow Jones Industrial Average bottomed out at 6,547. Yesterday’s close almost doubled that — 12,482. But Europe’s troubles have created tremendous volatility and slowed down the cycles. Consequently, I think we are now somewhere between an early and mid-cycle.

Historically speaking, that means financials, consumer discretionary, technology and industrials should have been the biggest beneficiaries of the early cycle. Let’s see how that worked out.

According to Morningstar (NASDAQ:MORN), the best sectors in the last three years were:

• Consumer cyclical (discretionary), 34.8%
• Technology, 29.3%
• Real estate, 26.2%
• Basic materials, 25.6%
• Industrials, 23.1%

That mostly followed history, but where was the financial sector? It gained about 14.2% — third from the bottom of all sectors. Not bad, but it gets worse: The one-year return was -13.9%.

Financials still haven’t recovered from the huge credit debacle that almost drove us over the edge. But it’s making progress. Consequently, I think we’ll see financials begin to improve soon, along with the other sectors that should do well in this cycle — technology, industrials, energy and materials.

So let’s talk about diversifying for this combo early/mid-cycle.

First, I think nearly all investors would benefit by having the following in their portfolios:

• Small-cap companies, with market caps from $300 million to $2 billion
• Mid-cap companies, with market caps from $2 billion to $10 billion
• Large-cap companies, with market caps of more than $10 billion
• International stocks
• Growth stocks
• Value stocks
• Dividend-paying stocks
• Fixed-income investments

The percentage devoted to each of these investments will greatly depend on your personal investment style and risk profile. But during this cycle, investors may want to focus on moving a larger percentage of their portfolios into mid- and large-cap stocks, adding a few dividend payers and more value stocks.

Of course, I believe there’s always a place for small-caps, growth stocks and international companies. Most investors can easily get global exposure via multinationals, but you should also be ready to test the waters of emerging markets when we see the tide change — not just yet, though.

Some investors will want to purchase individual stocks or bonds, and others will be happier with exchange-traded funds that offer a basket of investments in any of the above categories.

In my recent article on ETFs, 5 ETFs to Buy for Growth in 2012, I gave you a selection of basic exchange-traded funds that cover these sectors. Today, I’ve run my screens on individual equities, looking foremost at technical indicators that appear promising in the short term, followed by a selection of fundamental parameters. I was thrilled to see dozens of companies that look very interesting. Here are a few for your consideration:

Financials

American Capital Ltd. (NASDAQ:ACAS) is a private-equity company, and Ares Capital Corporation (NASDAQ:ARCC) is a business-development company. I had ARCC in my “Buried Treasures” portfolio at one time, and we saw a return of 82% in just eight months. I don’t see quite that stellar a return in the stock in the next few months, but I think you could still take home a double-digit gain. I believe both companies will benefit from an improvement in the credit markets.

For dividends, you might consider Duke Realty (NYSE:DRE), an industrial, office and retail real estate investment trust (REIT), currently paying a 5.4% dividend, or Huntington Bancshares (NASDAQ:HBAN), a regional bank with a 2.7% yield.

Technology

As you might expect, this is the sector in which I found scores of potentially good investments, but I’ll limit my recommendations to just a few.

Even though Steve Jobs is gone, I still feel that Apple Inc. (NASDAQ:AAPL) has plenty of momentum left. The company’s tremendous innovation thrust continues, and most analysts expect the shares to reach more than $500 in the next year.

If Apple’s shares are a little too rich for your pocketbook, you might consider Agilent Technologies (NYSE:A), a company that makes bioanalytical and electronic measuring systems, or that old stalwart, Cisco Systems (NASDAQ:CSCO), a business that has not performed very well recently but looks more promising as the recovery continues.

Industrials

Familiar names such as Boeing Co. (NYSE:BA), Deere & Company (NYSE:DE) and Caterpillar Inc. (NYSE:CAT) would fill out your portfolio nicely in this sector. They are all trading at very reasonable price-equity ratios, each pays close to a 2% dividend and they should continue to benefit as the global recovery strengthens.

If you’re feeling ready to speculate a bit, you might also think about adding homebuilders, such as Lennar Corp. (NYSE:LEN) and Toll Brothers Inc. (NYSE:TOL) to your portfolio to take advantage of the coming real estate recovery.

Energy and Materials

Many of the companies in these sectors seem undervalued, but I particularly like Agrium Inc. (NYSE:AGU), an agricultural-nutrient business, and BP PLC (NYSE:BP), which is recovering from its disastrous Gulf of Mexico oil spill and looks interesting for the days ahead.

These are just a few companies to help you transition your portfolio for the next sub-cycle. Of course, you should do your own homework and make sure that the stocks you select match your personal needs and goals. Happy Investing!