Protect Your Profits With This Essential Strategy

This article is part of our Better Investor series, in which The Motley Fool goes back to basics to help you improve your returns and be more successful with your investing.

So what have we learned so far in the Better Investor series?

We've learned that value stocks give you a proven way to profit over time. We've learned that the right growth stocks can give you the outsized returns that turn "savings" into "wealth." We've learned that small-cap stocks might keep you up at night -- but might also offer the best risk-reward trade-off out there. We've learned that dividend-paying large-cap stocks have been some of the market's top performers over the long haul. And we've learned that there's a whole world of opportunities in international stocks.

That's all great stuff. But how the heck do you fit all of those into one portfolio? Should you even try?

Embrace the power of "and"
We all know that putting all of one's eggs in a single basket is risky: Drop the basket, and you won't be making any omelets. Likewise, few investors would choose to hold just one stock, because we all know that even good companies can get into trouble. BP (NYSE: BP) was considered a great company with a great stock by many investors until last year's Deepwater Horizon disaster. But in the weeks following the explosion in the Gulf, the stock lost more than half its value (and later, a big chunk of its dividend), and it still hasn't fully recovered.

That's exactly the kind of risk that investors manage with diversification. Diversification, simply put, is about having multiple baskets for your eggs, baskets that are unlikely to be dropped all at the same time. By spreading your investing dollars out among different stocks, different classes of stocks, and even different classes of investments, you reduce the damage that one or two good-ideas-gone-bad will do to your overall portfolio.

There was no good way to anticipate the risk of BP before the disaster happened. But if your investing goal was to take advantage of rising oil prices, and you had split your oil-related investment dollars between, say, BP, Warren Buffett's favorite big oil company ConocoPhilips (NYSE: COP), and a top-notch oilfield services company like Schlumberger (NYSE: SLB), you would have had some insulation against a disaster affecting any one of your holdings.

But for most individual investors, you'll want to diversify even more broadly than that -- pairing an oil company with companies of other sizes in completely different businesses. Diversifying broadly helps reduce your exposure to more systemic shocks, like a sharp drop in oil prices that could have hurt all three of the stocks I named above. History teaches us that -- except during major economic crises, like the one we had in 2008 -- it's rare for all parts of the market to drop sharply at the same time.

But that said, diversifying too broadly isn't necessarily good, either. An overly diversified portfolio is going to look a lot like -- and perform a lot like -- an index fund. If your goal is to beat the market, that's not what you want. Where's the happy medium?

Seeking out a road map
I can't give you a one-size-fits-all map to an ideal diversification strategy. But if you have a 401(k) or 403(b) plan at work, your employer's plan provider probably has an online tool that will ask you a bunch of questions to assess your situation and tolerance for risk, and then provide you with a template for diversifying your investments.

From an asset allocation perspective, these templates sometimes tend to be a bit conservative -- by which I mean it might suggest that you hold more bonds and cash than is really necessary, especially if you're more than eight or so years from retirement. But look at what it suggests for the stock portion of your portfolio: Chances are, it'll suggest that you spread your dollars among growth stocks (think of companies like Apple (Nasdaq: AAPL), which is still a fast-growing tech company despite its recent earnings miss) and value stocks (out-of-favor but still-strong companies like General Motors (NYSE: GM), where the market cap is only a little higher than the company's cash on hand), large-caps and smaller-caps, and maybe domestic and international stocks. And it'll give you a rough idea of how much money to allocate to each category.

Now, you don't need to follow the plan exactly -- it's a template, not marching orders. And you don't need to fill each category with individual stocks. Buying an ETF that covers a given category, like Vanguard Small Cap Growth ETF (NYSE: VBK) or iShares Dow Jones Select Dividend Index (NYSE: DVY) (a decent large-cap value fund) is a fine strategy for those categories you don't feel ready to cover with individual stocks.

But in today's choppy market, whether you do it with stocks or funds, it's important to make sure your portfolio is doing a good job of spreading the risk around.

If you'd like to learn more about ETFs, including the names of three funds identified by Motley Fool analysts as good bets in today's market, just click to claim a copy the Fool's special report, "3 ETFs Set to Soar During the Recovery." It's completely free for Motley Fool readers.

Stay tuned throughout our Better Investor series and get the advice you need to succeed with your investments. Click back to the series intro for links to the entire series.