One thing that often gets lost in all of 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 (67% total average returns versus 28% in the S&P 500). So it can be done.
You, too, can construct a portfolio in a sensible enough way to 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 Merck (NYSE:MRK) and Eli Lilly (NYSE:LLY) already make up a big chunk of your holdings, it's best to avoid another drug manufacturer when buying more stock. Even if you think it would provide you with great returns, if the industry falls apart (translation: you end up being wrong), you'll be in for a lot of pain. Even if you are eventually right in your analysis, you'll still be in pain if you have to sell unexpectedly and the industry remains depressed for an extended period.
The next logical step, then, is to aim for great stocks with a low or negative correlation (click here for more information on this fascinating topic). That simply means that although they'll all hopefully rise in value over the long term, the stocks will tend to move in relatively different directions along the way. One zigs, the other zags, and your portfolio's returns will be much smoother as a result. Consider NetEase.com (NASDAQ:NTES) and Boeing (NYSE:BA). It makes intuitive sense that the Internet and defense/aerospace industries would not move in lockstep, and a three-year chart shows this to be true.
The best news is that it's fairly easy to gain this benefit. It doesn't take a detailed scientific analysis. In his classic book A Random Walk Down Wall Street, Princeton professor Burton Malkiel notes that "anything less than perfect positive correlation can potentially reduce risk."
The right way to do it
Here's a good example. In Stock Advisor, Tom refers to his method as "industry rotation." His goal is to find the best companies in beaten-down industries that are ready to rebound. Such stocks are among the market's best performers when the turnaround comes, as it inevitably does in a relevant industry. Think of how Brinks (NYSE:BCO) and Armor Holdings (NYSE:AH) moved ahead when the security industry recovered -- each easily topped the market over the past few years.
When the Stock Advisor service began in early 2002, Tom saw value in the financial- and business-services sector, and picks such as Moody's have nearly tripled in value since. He then moved on to health care, a sector in which he recommended companies several times in 2003. After that, he liked the potential in tech stocks, particularly the semiconductor sector. Again, he found success. Nowadays, he's looking for bargains in another industry.
Let's take a look at two of his stocks from different industries to highlight the diversification benefit. BorgWarner supplies powertrain parts to auto manufacturers. Quality Systems provides medical-records software to doctors and dentists. Both have achieved stellar gains since Tom recommended them in early 2003 (115% and 538%, respectively). But they moved differently enough so that their combined return (especially in the early months) was much smoother than either of them achieved separately.
The Foolish bottom line
I don't use these examples to applaud Tom and David's stock-picking skills. Rather, my aim is to highlight the importance of diversification, even when choosing a relatively small number of stocks. Certainly, 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.
Right now, a 30-day free trial to Stock Advisor will not only get you every recommendation they've ever made, but you'll also be able to follow Tom along the industry carousel. Plus, each newsletter now includes Tom or Dave's top five stocks 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. NetEase is a Rule Breakers recommendation. Lilly is an Income Investor pick, and Merck is a former Income Investor pick. The Motley Fool is investors writing for investors.
