One thing that often gets lost in all the talk of sizzling stocks and 20-baggers is the benefit of diversification. It's a concept every investor can understand and profit from.
And don't think diversification automatically means mediocre returns. David and Tom Gardner have led Motley Fool Stock Advisor members through a variety of industries, and even some international exposure, on the way to outsized performance (64% total average returns versus 25% in the S&P 500). So it can be done.
You, too, can construct your portfolio in a way so sensible that you significantly lower your risk -- even if you own very few stocks. Here's how.
Negative is good
Always try to consider how each potential new purchase relates to the rest of your portfolio. If Intel and Advanced Micro Devices (NYSE: AMD ) already make up a big chunk of your holdings, it's best to avoid a similar firm when buying more stock. Even if you think it would provide you with great returns, if the semiconductor industry fell apart (translation: you ended up being wrong), you'd be in for a lot of pain. Even if you ended up being right in your analysis, you'd still be in pain if you had to sell unexpectedly and the industry remained depressed for an extended time.
The next logical step, then, is to aim for great stocks with a low or negative correlation. That simply means that although they'll all hopefully increase in value over the long term, they will tend to move in relatively different directions along the way. One zigs, the other zags, but it's OK: Your portfolio's returns will be much smoother as a result.
The best news is that it's fairly easy to gain this benefit. In his classic book, A Random Walk Down Wall Street, Princeton professor Burton Malkiel says, "Anything less than perfect positive correlation can potentially reduce risk." He's right. One example that comes to my mind is how well defense-related stocks such as Lockheed Martin (NYSE: LMT ) and Raytheon (NYSE: RTN ) performed in the wake of Sept. 11, when most of the market was suffering.
The right way to do it
In Stock Advisor, Tom refers to his method as "industry rotation." He pores through beaten-down industries, seeking the best companies that are ready to rebound. These stocks become some of the market's best performers when the turnaround comes, as it inevitably does in a relevant industry. Think of how Amazon.com (Nasdaq: AMZN ) rocketed ahead when Internet stocks recovered -- up more than 1,000% from its low.
When the Stock Advisor service began in early 2002, Tom saw value in the financial and business services sector, and recommended companies such as Corporate Executive Board, which has more than doubled in value since. He then moved on to health care, recommending companies in that industry several times in 2003. The average total return of those 10 stocks is 144% (compared to 54% for the S&P 500). After that, Tom liked the potential in tech stocks, particularly the semiconductor sector. Then he looked for bargains in the retail industry.
Let's take a look at two of his stocks from different industries to highlight the benefits of diversification. Costco (Nasdaq: COST ) operates wholesale clubs. Sanderson Farms (Nasdaq: SAFM ) is a poultry processor. Both have enjoyed solid gains since Tom recommended them in 2002. But they moved differently enough so that their combined return (especially in the early months) was much smoother than either achieved separately. (Tom has since recommended selling Sanderson Farms.)
I don't use these examples to applaud Tom's stock-picking skills. Instead, my goal is to reiterate the importance of diversification, even when choosing a relatively small number of stocks. Not all stocks will be winners, but by spreading picks across sectors, you're giving yourself a chance for sensible diversification -- and a smoother road to long-term success.
A 30-day free trial to Stock Advisor will let you see every recommendation the Gardners have ever made. Plus, each newsletter includes Tom and David's top stocks (five for each brother) to buy now. Here's more information.
This article was originally published as "Are You Invested in the Right Industries?" on April 5, 2006. It has been updated.
Rex Moore never met a deadline he didn't meet. At time of publication, he owned no companies mentioned in this article. Amazon.com, Costco, and Corporate Executive Board are current Stock Advisor recommendations. Intel is an Inside Value pick. The Motley Fool is investors writing for investors.