The Simple Strategy That Could Save Your Portfolio

Let's get this out of the way up front: This article will not discuss nine-baggers or stocks that can turn thousands into millions.

There's a potentially profitable takeaway, though, so I hope you'll stay with me.

The dirty "D" word
Talking about diversification is as much fun as talking about your last dentist appointment. It's just not something you do in mixed company, lest you run the risk of boring even the most excitable retail investors.

But a very simple strategy of (1) thinking about your portfolio holistically and (2) diversifying into quality investments that don't perfectly correlate can really have an effect on your bottom line.

Really. In March, The Wall Street Journal ran an eye-opening story about "the lost decade" of stock market returns: "The stock market is trading right where it was nine years ago. Stocks, long touted as the best investment for the long term, have been one of the worst investments over the nine-year period, trounced even by lowly Treasury bonds."

Emphasis mine
To be blunt, Treasury bonds took some high-profile stocks behind the woodshed -- Pfizer (NYSE:PFE) and Time Warner (NYSE:TWX) are notable examples. Even megacaps Microsoft (NASDAQ:MSFT), Merck (NYSE:MRK), and Citigroup (NYSE:C) were outperformed by T-bills.

That's scary, but don't reach for the rip cord just yet. For one, the period in question starts at an artificially high moment in time -- March 1999, midway through the inflating tech balloon. Had you started two years later, it'd be a different ball game altogether.

Nonetheless, stocks were hot in 1999, and Americans were gobbling them up. Not only were discount brokers going mainstream, but domestic equity funds also saw net cash inflows of nearly $190 billion that year.

The moral to a grim story
But here's the thing … you'd have done much, much better if you'd tuned out the "Internet revolution!" chatter back in 1999 and searched the entire investment landscape for quality companies.

Just look at the stats:

Source: Morningstar, as cited in The Wall Street Journal.

I'm not suggesting anyone should've known to go whole-hog into emerging-market stocks in March 1999. I don't believe it's possible to possess such predictive powers in combination with the courage to make a concentrated bet.

Far from it, in fact. These stats, though, illustrate the need to take off the blinders and consider all asset classes for your portfolio. Yes, this shows that diversification would've done you right over the past nine years.

If you'd taken a very conservative allocation, for example, and done 80% in the S&P 500 and 20% in developed-country stocks -- investing in megacap stalwarts like, say, BP (NYSE:BP) and Vodafone (NYSE:VOD) -- you'd have made an additional $1,069, not counting trading costs or fund expenses.

Don't get carried away
Diversification is not "owning a little bit of everything." Nor is diversification an end in itself. Similar to what my colleague Bill Mann is fond of saying, we should want our money invested 0% in companies that stink and 100% in companies that don't. Simple enough.

Fund manager Ron Muhlenkamp puts it more eloquently:

Some people selling investment advice … speak or write of diversity as if it were the goal of investing. It's not! The goal of investing is to increase the purchasing power of your assets -- to make you money. Any potential investment should be measured by the likelihood of making you money. Any potential investment which is unlikely to make you money should be discarded.

So while spreading your bets across asset classes that are dissimilar can help soften the blow when one asset class lags, never, ever sacrifice quality for variety.

Get started with the simple strategy
To get you started, here are some things to consider:

• Think about your portfolio holistically -- jot down the investments you (and your spouse) have in 401(k)s, IRAs, taxable accounts, and so on. There's no need to diversify within each account, as long as you're sufficiently diversified across accounts.
• Do not diversify simply for the sake of diversification. As Peter Lynch wrote, "A foolish diversity is the hobgoblin of small investors."
• If you buy and sell individual stocks in your taxable account, what are the fund choices in your 401(k)? Owning the Vanguard 500 in your 401(k), for instance, doesn't make much sense if you hold ExxonMobil, General Electric, and AT&T -- top holdings of the fund -- in a taxable account. Remember also that your 401(k) fund choices can provide solid selections in areas where you may have no expertise, whether real estate, health care, emerging markets, or something else.

So don't go out today and buy one REIT, or one small cap, or one foreign stock simply to own one REIT, small cap, or foreign stock. But don't ignore the similarities of your holdings, either. If you'd owned nothing but small-cap banks a year ago, for instance, you'd have been in major pain.

A well-crafted portfolio doesn't build itself. For a little help putting the right assets in the right places -- and for ready-made model portfolios -- I recommend that you sample our Rule Your Retirement service. In addition to those model portfolios, you'll find specific stock and fund recommendations and a how-to workbook on planning the perfect retirement. If you're interested, click here for a free month-long trial without obligations to subscribe.

After all, having your portfolio squared away will just free you up for the more exciting aspects of investing -- like hunting for that nine-bagger.

Brian Richards owns shares of Microsoft but no other companies mentioned. Microsoft is an Inside Value recommendation. Time Warner is a Stock Advisor selection. Pfizer is an Inside Value and Income Investor pick. The Fool has a disclosure policy.