The Closest Thing to a Free Lunch

Proper diversification is about the closest thing to a "free lunch" available to ordinary investors. When done right, it can buttress your overall portfolio from a company's catastrophic failure without significantly impacting your total long run returns.

It's an important tool for your investing arsenal, simply because none of us have perfect foresight as to what the market -- or any company in the market -- will do. Since we're all pretty much guaranteed to be wrong from time to time, it's critically important to have a way to assure that one incorrect move won't sink your entire portfolio.

How to make it work
Central to the concept of diversification is the need to own stocks that operate in different industries. That way, if one company you own fails, it's far less likely to take down the rest of your portfolio along with it. That's important -- but just blindly buying stocks because they're in different industries isn't enough. After all, they could all be duds. And the more duds you own, the lower your overall performance will be.

So in addition, it's also important that the stocks you buy are ones you have a reason to believe are worth owning on their own. That way, you're not risking di-worse-ification by buying clearly bad stocks just for the sake of diversifying.

Benjamin Graham -- the father of value investing and the man who taught investing to Warren Buffett -- likened this combination to playing roulette, only as the casino rather than the gambler. The occasional spin may go against the casino, but over time, the house generally wins.

So what stocks are worth owning?
The toughest part is figuring out which stocks are worth owning. In hindsight, it's fairly straightforward to look back and say "wow, I wish I had bought that stock 20 years ago." Unfortunately, we don't have the benefit of investing by hindsight, so we have to project the future based on what we know, today.

And over time, one metric that tends to be a decent harbinger of future returns is how well a company's management treats its shareholders. If a company makes both paying and regularly raising its dividend a priority, chances are good that it is structuring its business to be financially sound enough to support that priority for the long run. And in fact, there's good reason to believe that over the long run, such companies can actually outperform the broader market.

Fortunately, solid dividend paying and growing companies can be found across multiple industries. That makes it fairly straightforward to diversify while buying stock in companies that all share that same long-term investor-focused characteristic. The table below shows what would have happened if 20 years ago, you had bought a diversified handful of companies with some of the longest streaks of consecutive annual dividend increases in their respective industries:

Source: DripInvesting.org, Yahoo Finance.

Diversification benefits are real
Of course, it's easy to look backwards and find great companies to have invested in. But what you didn't know 20 years ago was that the banking industry would collapse and take many former giants along with it. So, what if instead of $1,000 in each of those nine stocks, you instead invested your $9,000 by buying $900 in each of them, along with another $900 in one ultimately failing bank stock?

Yes, you would have wound up with a bit less than had you never invested in that failure. But as the table below shows, even a complete loss from that one stock would have only knocked your annualized return down a mere 0.6%:

That's not bad for a portfolio where 10% of your invested capital got sent to a company that turned out to be worthless. Yet imagine what would have happened if you had put all your cash in the stock of that failed bank.

Ultimately, your money is at risk whenever and however you invest it. But by diversifying across industries while still investing in companies that look like they've got the strength to survive for the long run, you can protect yourself from a complete failure. It may not be a completely free lunch, but it sure is cheap for the value you get from it.