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 (77% total average returns versus 32% 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 Toyota (NYSE:TM) and General Motors (NYSE:GM) already make up a big chunk of your holdings, it's best to avoid buying stock in another automaker, even if you think it would provide you with great returns. If you're wrong, and the auto industry falls apart, you're going to be in for a lot of pain. Even if you were correct in your analysis, you'd still be in pain if you had to sell unexpectedly and the industry remained depressed for a long 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 rise in value over the long term, they 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.

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 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 strong discount brokers like E*Trade (NASDAQ:ETFC) and TD Ameritrade (NASDAQ:AMTD) recovered after the bubble popped -- each at least doubling from its lows.

When the Stock Advisor service began in early 2002, Tom saw value in the financial and business services sector, and picks like Moody's (NYSE:MCO) have 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 health-care stocks is 169%. After that, he liked the potential in tech stocks, particularly the semiconductor sector. Again he found success. Recently, he's been looking for bargains in the retail 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 (NASDAQ:QSII) provides medical-records software to doctors and dentists. Both have achieved stellar gains since Tom recommended them in early 2003 (245% for the former, 535% for the latter). But they moved differently enough so that their combined return (especially in the early months) was much smoother than either of them achieved separately.

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 get you not only every recommendation they've ever made, but you'll also be able to follow Tom along the industry carousel. Plus, each newsletter 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 Apr. 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. The Motley Fool is investors writing for investors.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.