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 (65% total average returns versus 29% in the S&P 500). So it can be done.
You, too, can sensibly construct your portfolio 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 Cisco (NASDAQ:CSCO) and Juniper (NASDAQ:JNPR) already make up a big chunk of your holdings, it's best to avoid another networking specialist 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'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 period.
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. Even archrivals Microsoft and Apple (NASDAQ:AAPL) have different enough business models to provide some low correlation.
The right way to do it
In Stock Advisor, Tom refers to his method as "industry rotation." His goal is to look at beaten-down industries and find 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 a company like Johnson & Johnson (NYSE:JNJ) shed 30% to 40% of its value under the threat of health-care reform in 1993 and '94. Yet opportune buyers have seen 600% to 700% gains (with dividends reinvested) in J&J since then.
When the Stock Advisor service began in 2002, Tom saw value in the financial and business services sector. One business he recommended, Corporate Executive Board, has more than doubled in value since. He then moved on to health care, recommending companies in that industry several times in 2003, including Laboratory Corp. (NYSE:LH), which has doubled. After that, Tom liked the potential in tech stocks, particularly the semiconductor sector. Again he found success. Nowadays, he's looking for bargains in other industries.
Foolish bottom line
I don't use these examples to applaud Tom and David's stock-picking skills. Certainly not every recommendation is a winner -- the June 2003 pick of First Health Group (later acquired by Coventry Health Care (NYSE:CVH)), for example, is still struggling to keep up with the market.
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.
Right now, a 30-day free trial of Stock Advisor will let you see every recommendation the Gardner boys have ever made. Plus, each newsletter now includes Tom and 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. Of the companies mentioned in this article, he owns shares of Microsoft and Johnson & Johnson. Microsoft is an Inside Value pick. Johnson & Johnson is an Income Investor pick. The Motley Fool is investors writing for investors.
