When the market goes up or down, it doesn't always happen evenly. Some companies and entire industries can do well when the rest of the market is falling, and some can do poorly when everything seems to be going well.

Eggs

Source: 401kcalculator.org via flickr.

In order to make sure you're protected no matter what the market does, make sure your portfolio is well diversified. But what exactly does that mean and why is it so important? How much exposure to one stock or to one sector is too much?

The importance of diversification
Diversification is important because different stocks and industries react in different ways to economic and market conditions.

For example, the S&P 500 has gained about 180% since hitting bottom in March 2009.

^SPX Chart

However, the difference between sectors is substantial. Some sectors, such as industrials (XLI on the chart below) and financials (XLF), have outperformed the S&P, while energy (XLE) and consumer staples (XLP), among others, have underperformed.

XLP Chart

The performance (or lack thereof) of some major companies in these sectors could make or break a portfolio. For example, within the energy sector, oil and gas giant ConocoPhillips has increased in value by 162% since the market bottom.

On the other hand, leading drilling contractor Transocean has declined by 45% since that point. Someone with disproportionate exposure to the company would have missed out on a lot of the market's gain over the past five years.

Are too many of your eggs in one basket?
The most obvious way to spot a lack of diversification is if you own too much of one single stock. Sure, if you own 20 stocks in six different industries your holdings might sound diversified, but if Bank of America stock represents 30% of your account's value, things are probably a little out of whack.

The second thing to look for is having too much of your money tied to any single industry. If six of your 10 stocks are banks, you aren't diversified. Sure, poor performance by any one bank would not decimate your portfolio, but what if the entire sector took a plunge like it did in 2009?

The last thing to check for is not so obvious. Even if you have different companies in different industries, they could still be closely connected to one another. For example, spiking oil prices would affect many companies in various industries. Auto sales could suffer, transportation costs would soar, and daily expenses would rise for consumers, leaving less money for discretionary purchases.

So while Ford, Delta Air LInes, Carnival Cruise Lines, and Target might seem like completely unrelated companies, they actually are all rather dependent on similar economic factors.

Of course, it's not possible to eliminate all of this "crossover" in your portfolio. However, you don't want something like rising oil process or spiking interest rates to decimate your entire stock holdings. Proper diversification can prevent any single economic event from causing too much harm to your investments.

What a well-diversified portfolio looks like
Being diversified doesn't necessarily mean you need exposure to every single sector in the market. For example, if you don't understand biotech companies, it's completely fine to leave them out of your portfolio.

My rule of thumb is to have exposure to at least five distinct industries in a portfolio, with no more than 25% of your holdings connected to any single one of them. Within each industry you should spread your holdings out over a few different companies. No more than 10% of your money should be tied up in any single stock.

After all, if you allocate 20% of your portfolio to tech stocks but only own Apple, you're vulnerable if the company starts doing poorly. However, if you divide that 20% between, say, Apple, Microsoft, and Cisco, a bad quarter from one won't have such a drastic impact on your portfolio.

The next steps
Take a few minutes and look at your own portfolio. Do any of your stock holdings represent a large chunk (more than 10%) of your entire account? Do you have too much exposure to any one sector? And are any of the stocks you own too reliant on the same areas of the economy?

If so, it might be a good idea to think about doing a little rebalancing. There are plenty of great companies to choose from. Why take too much risk on any one of them?

Matthew Frankel owns shares of Bank of America and Transocean. The Motley Fool recommends Apple, Bank of America, Cisco Systems, and Ford. The Motley Fool owns shares of Apple, Bank of America, Ford, Microsoft, and Transocean. Try any of our newsletter services free for 30 days. We Motley Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.