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The Surprising Poker Lessons That Led Me To 50% Gains

Wednesday, May 22, 2013 - 2:30pm

Every stock investor has heard about the importance of diversification.

In fact, I have emphasized many times in my articles just how critical being properly diversified is when managing a successful long-term portfolio. Diversification is not just critical for a long-term portfolio -- it is the primary key for survival in the stock market.

Massive bull markets, like the one taking place now, can have the negative effect of causing investors to become complacent, take too many risks, and not diversify correctly.

I know from experience that it is difficult not to go "all-in" on a hot stock. During the dot-com boom of the late 1990s, one Internet stock in particular just seemed to be going up day after day.

Noticing the uptrend, I decided to liquidate my portfolio and go all-in with this stock. Ignoring everything I knew about diversification, I used all of my capital and leverage, purchasing a large number of the outstanding shares.

As you may expect, Murphy's law was in full force, and the bad news hit the newswire on my second day of ownership. The stock that had climbed day after day, week after week and month after month suddenly took a nosedive. By the time I could dump the shares, I had lost about a quarter of the hard-earned money in my account.

Had I remained diversified and only purchased a sensible number of shares, the damage to my meager account would have been much less.

Despite hearing about it all the time, many investors don't know what diversification is or how to properly diversify a portfolio. Let's begin with a definition.

"Diversification is a method of portfolio management whereby an investor reduces the volatility (and thus risk) of his or her portfolio by holding a variety of different investments that have low correlations with each other," according to InvestingAnswers.

Remember, smart investing is a trade-off between risk and return. It isn't an all-in gamble on a single stock. Think of diversification of a way of spreading risk.

Diversification is a personal choice based your needs, goals and time frame. My personal rule of thumb is to offset or hedge each risky position with something considered more stable, if less profitable.

Clearly, this 1-to-1 level of hedging isn't for everyone. I don't always stick to the rule, but it provides a basic framework for building a diversified portfolio.

With this in mind, here are four guidelines for diversification.

1. Diversify Between Asset Classes
Asset classes are different types of investments.

Exchange-traded funds (ETFs) allow investors to diversify across asset classes without having to step outside of a regular stock brokerage account.

The primary asset classes include equities, bonds, commodities, currencies and real estate. Building a portfolio that comprises each of these is one way to diversify. For example, if you are concerned about structural risk, rather than purchasing real-estate investment trusts (REITs) through your brokerage account, you could purchase actual investment property.

The same goes for precious metals and other investments. If you are worried about the integrity of the stock market or individual brokerages, buying the physical counterpart makes good sense as a diversification tool.

2. Diversify Across Securities Within Each Asset Class
This means to invest in mutual funds, ETFs, managed funds and individual equities within each of the primary asset classes.

An example would be to own SPDR Gold Trust Shares (NYSE: GLD), a mining company ETF, as well as a gold-based mutual fund. As stated above, hard-core diversification would include the physical metal, as well.

3. Diversify Across Fund Families And Money Managers
This strategy mitigates management risk.

In today's environment, the risk of internal fraud, negligence or mismanagement runs high. This is why investing into several different fund families and money managers will help prevent you from being wiped out should one of the management companies have unexpected financial problems.

Bear in mind that this does not protect you from a structural breakdown of the financial marketplace. If this occurs, we will all have greater worries than our stock portfolios. That said, physical assets such as real estate and precious metals could mitigate losses in true economic disaster-type situations.

4. Diversify Across Time
This is one of the most powerful yet least understood methods of diversification. Buying into a stock across time rather than all at once is a smart move in most market conditions.

The one time it doesn't make sense is during times like now, when a roaring bull market would create larger returns if all the capital had been invested all at once rather than over time.

But unfortunately, the good times are only observable in hindsight. Therefore, "woulda, coulda, shoulda" reasoning does not negate the importance of diversifying across time with your investment purchases.

No one can time the market exactly. Investing on a regular basis, rather than all at once, can result in larger and safer returns.

Risks to Consider: Proper diversification mitigates risk rather than increasing it. Obviously, spreading out risk will lessen your portfolio's upside, but the benefits far outweigh the possible gains over time.

Action to Take --> The first step is to review your portfolio to assure that it is properly diversified for your needs. Using the ideas above is a good way to start.

P.S. -- StreetAuthority's Amy Calistri has one objective for readers of Stock of the Month... to provide one quality stock pick each month, with in-depth analysis in plain English that investors can understand. In fact, she just released a special presentation, "How to Beat the Stock Market... In Just 12 Minutes per Month," that tells you more about her strategy. Go here to learn more.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.