Benchmarking -- comparing your portfolio's performance to that of an index -- is a common way to evaluate your stock-picking skills over time. After all, if you can get similar returns by just buying an index fund, why bother doing all the work of picking stocks? But there's another dimension to benchmarking that some investors find very useful in organizing their thinking: using a benchmark index as a template for diversifying your portfolio. Can you really use an index to beat an index? Read on!

The problem: concentration
Many investors, after making the decision to educate themselves and start picking stocks, follow a strategy of picking companies they "know" -- firms they've done business with, in industries or sectors that they know a lot about. That approach brought Peter Lynch (and a lot of individual investors) a great deal of success, and there's a lot to be said for it. But some who practice this strategy end up with a portfolio that's heavily concentrated in one or two industries, and if one of those industries takes a nosedive, those portfolios can take a big hit, no matter how good your stock picking has been.

For instance, if you work in the auto industry, cars are what you "know." It's tempting to load up your portfolio with names like Toyota (NYSE:TM) and AutoNation (NYSE:AN) and Magna (NYSE:MGA) and maybe a little bit of Ford (NYSE:F) (because you like the new Fusion sedan and think the company might finally be on an upward swing). But if you succumb to that temptation, an auto slowdown is going to be painful for you. And it'll be extra painful if the overall market has a strong year while your favorite sector gets hammered.

Enter the index
When you recognize that your portfolio is, perhaps unintentionally, overweighted in one industry or sector, it's time to diversify. Here's where the index comes in: the sector components and weights of any well-constructed index (as opposed to a simple average like the Dow) can serve as a roadmap for the diversification of your own portfolio. Note that I said a roadmap, not a strict guide -- you can choose to overweight (or underweight) some sectors, especially if you think that certain sectors are likely to outperform the market in coming months. In fact, one of the advantages of this approach is that it invites you to question your decisions to overweight or underweight, and to make adjustments when things seem out of whack.

Here's how the S&P 500's sector weightings break down, as of March 2007:





Information Technology


Health Care




Consumer Discretionary




Consumer Staples




Telecom Services




Source: Standard & Poor's

So what do we do with this information? Some prominent (and successful) investors -- Ken Fisher is one -- insist that one's portfolio should always track the sector diversification of its benchmark index, unless one has a specific reason for over- or underweighting. For instance, if you anticipate a sharp decline in oil prices, you might choose to underweight your energy holdings versus the benchmark. But generally speaking, according to this line of thinking, you should stay close to the index's weightings and get a performance advantage by choosing and holding only the best stocks in each sector.

Making it work
Personally, I don't follow that advice exactly as written -- partly because I don't want to hold and follow 30 or 40 individual stocks, and partly because there are whole sectors where I don't feel I have a stock-picking advantage versus the market. I'm a big proponent of investing only when I feel I have an advantage -- when I think I'm seeing something that the overall market is missing. (This is another point Ken Fisher hammers home in his writings, and it's a good one to take to heart.)

What I do is take positions in good stocks as I find them, while keeping the rest of my portfolio invested in index funds (or ETFs). This gives me much the same effect -- I'm holding the index, except where I think I have an advantage. If I've managed to pick several market-beating stocks, my overall returns will look pretty spiffy when compared with those of the benchmark index -- and so far, they have. But I do check back with the index from time to time to make sure that my stock picks make sense with my overall diversification strategy. It's all too easy to get concentrated in one sector I "know," if I don't step back and review the big picture on a regular basis.

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Fool contributor John Rosevear does not own shares of any of the companies mentioned. The Motley Fool has a disclosure policy.