As the stock market marches steadily higher, you may feel increasingly uncomfortable with the level of risk in your portfolio. Although it's nearly impossible to completely eliminate risk, the right diversification strategy can give you the best odds of weathering whatever economic storms may hit the market in the future.
But diversification isn't just about adding a bunch of extra investments to your portfolio. If you overdo it, you can end up with a portfolio that looks more like an index fund than a uniquely tailored assortment of investments -- and it'll be almost impossible for your returns to beat the market by a very wide margin. So if you don't want to give up and accept completely passive investing, how can you cut your portfolio risk without giving up too much potential return?
2 strategies to consider
There are a couple of different ways you can add portfolio diversification without watering down your return potential too much. With one strategy, you diversify within a particular industry while maintaining a focus on that sector. That way, if the sector overall does well, you'll benefit -- without having to guess which particular company will be the eventual winner.
As an example of how this strategy can work, take the fertilizer industry. Fertilizer has been a hot commodity in recent years, as high prices for farm products have put a lot of money in farmers' pockets, giving them the financial resources they need to take measures to boost their crop yields. That in turn has increased fertilizer demand, boosting shares of PotashCorp (NYSE:POT), Mosaic (NYSE:MOS), and other companies focused on farm productivity.
But if you remained concentrated on those particular stocks, then you've missed a big move in the fertilizer sector recently. That's because while those two stocks have given shareholders mediocre performance lately, rivals Terra Nitrogen (NYSE:TNH) and Rentech Nitrogen Partners (NYSE:RNF) have put up much better numbers. The reason: Nitrogen-based fertilizer has become much more inexpensive because of rock-bottom natural-gas prices, from which many fertilizer makers get the nitrogen they need for their production.
To implement this strategy, you could either add shares of different stocks within the industry or choose a sector-specific ETF that gives you multiple plays in the sector. For instance, for fertilizer stocks, the Global X Fertilizers/Potash ETF (NYSEMKT:SOIL) offers a couple dozen companies with ties to fertilizer. That's more than enough to give you broad exposure while still letting you hold on to individual stocks if you prefer.
Divide and conquer
The other broad diversification strategy is to add a number of unrelated stocks that have roughly similar risk levels to the existing positions in your portfolio. That way, if your investing thesis in one area proves to be dead wrong, you still have other positions that will help you get past your mistake.
This strategy is more familiar to those considering ways to diversify their investments. For instance, if you own fertilizer stocks like the ones mentioned above, then making another high-risk call in a completely different sector gives you two chances to make the right call. Whether it's a high-risk medical-device stock like Intuitive Surgical or a volatile Internet travel play like priceline.com, it's hard to argue that those stocks would move in lockstep with the agricultural side of your portfolio.
Is it worth it?
Any strategy that adds diversification reduces both risk and potential reward. So if you really want to gamble your entire nest egg on a single stock, you're not going to be happy with any level of diversification.
But if you're like most investors, risk isn't something you want more of than you can handle. In those cases, following a strategy that still lets you profit from your investing prowess when your calls prove correct is especially valuable. That's how the right diversification strategy can not only help you outperform the market but also leave you with a safer portfolio as well.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Intuitive Surgical and Priceline.com. Motley Fool newsletter services recommend Intuitive Surgical and Priceline.com. Try any of our Foolish newsletter services free for 30 days. We 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.