The Missing Link in Your Portfolio

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When everything seems to go wrong, smart investors go back to the fundamentals. If you haven't taken a close look at everything in your portfolio lately, you might overlook something that's missing -- and the big impact it could have on your future returns.

As you peruse the investments you own, one of the first things you should notice is whether your portfolio is truly diversified. Diversification has its good points and bad. But if you decide to go with a concentrated portfolio, with just a few different stocks and sectors represented, it's important to do so with open eyes and a complete understanding of what you may be getting yourself into.

The upside of diversification
"Diversification" has different meanings to different investors. Some look to own a dozen or more different mutual funds, representing tiny pieces of thousands of different stocks. Others find a few dozen individual stocks sufficient to protect themselves from potential problems.

To me, diversification isn't just about the number of stocks or funds you own. It's about what types of investments are in your portfolio, and the strategies that you follow in selecting those stocks. You can own lots of different stocks, but still have a portfolio concentrated in a particular sector or industry.

It doesn't take a huge number of investments to get sufficient diversification. For instance, I can give you a reasonably diversified portfolio that covers all the bases with just three exchange-traded funds:

Fund	Styles Covered	Holdings Include
Vanguard Value ETF (VTV)	Value investing, dividend investing	ExxonMobil (NYSE: XOM), Johnson & Johnson (NYSE: JNJ)
Vanguard Small-Cap Growth ETF (VBK)	Small-cap investing, high-growth investing	Itron (Nasdaq: ITRI), Dresser-Rand (NYSE: DRC)
Vanguard Total World Stock ETF (VT)	International investing, large-cap blend investing	BP (NYSE: BP), Total (NYSE: TOT), Novartis (NYSE: NVS)

Source: Morningstar.

As you can see, those three funds don't just give you exposure to hundreds of different companies. They also span across several different investment strategies, including both large and small companies, growth and value investing, and domestic and international companies.

It's pretty easy to put together a diversified portfolio. But just because it's easy doesn't mean it's the best solution for everyone.

When concentrated is best
Opponents of diversification point out that it basically amounts to a cop-out. Rather than doing research on a handful of promising investment opportunities and committing a large portion of your money to them, you instead spread your bets across so many different picks that no one success or failure will make a huge difference to your overall returns.

Obviously, if you're concerned about preserving capital in the event you pick a bad stock, diversification works in your favor. But if you're hoping to score big returns on just a few great investment ideas, then you'd much rather have a concentrated portfolio to get as much bang for your buck as you can. Or as Warren Buffett said more concisely, "Diversification is protection against ignorance. It makes very little sense for those who know what they're doing."

Back to fundamentals
So after you look at your portfolio, what's the next step? If you got burned last year, and your self-confidence is hurting, you may want to reevaluate the strategy you've been following to see whether it's really in line with your style.

If concentrating your investments on one or two ideas worked in the past, but failed miserably in 2008, re-diversifying for a while can give you time to figure out what went wrong and correct the problem. Conversely, if a diversified portfolio didn't give you as much protection as you expected, then consider whether concentrating on your best ideas would give you greater prospects for big gains when the market turns.

More on bear-market investing:

• Our picks for the best stocks of 2009.
• Should you be thinking about selling now?
• Great bargains for investors are everywhere.