Diversification:

What it is and why you need it

ShareBuilders often begin by investing in just one or two stocks-and that's fine. A year later, some ShareBuilders keep right on investing in just one or two stocks-and that could be a long-term mistake in the making.

If you're already investing with ShareBuilder, you probably thought long and hard before picking stocks you believe in. Stocks you think will grow and prosper over the “long-term"-ten, fifteen, twenty years.

But every investment carries risk. However sound your judgment about your investment portfolio, no one stock is bulletproof. Markets change, technology changes, luck changes. Once in a while, even a great stock will head south for the winter and not come back. Secondly, a personal emergency might force you to sell investments when you didn't plan to. Even excellent long-term investments have temporary downswings. And Joe Pundit's assurance that the current 20% "market correction" will only last six months is going to be cold comfort-even if true-when you need cash by next Monday.

Diversification is your most basic tool for controlling your exposure to these risks. Let's suppose you currently invest in just Global Widget, and you want to diversify from one to two stocks. Global Widget is a "value" stock: an industrial company that has grown slowly for decades but may be undervalued. Now, buying a second stock with the same general description (say, that great old company American Doohickey) would be diversifying. But not much: two similar stocks in the same sector of the economy have a tendency to do good or bad at the same time. So let's suppose that your second investment is a totally different creature: DigiMed, a successful and aggressively expanding medical software company.

The beauty of the second choice-assuming, of course, that both companies are well-managed and essentially sound-is that growth stocks and value stocks tend to rise and fall in value at different times.

This is a simple example, and the real economy is a lot messier-but you see the point: taken as a whole, your newly-diversified portfolio on average suffers from fewer extremes over time:

The example is fictional - but something very similar happened for real, and on an especially large scale, in 1999-2000. People with narrow technology portfolios saw their wealth first double and then halved in that period. People with narrow "Old Economy" portfolios had a less extreme version of the opposite experience. A third group-investors with good diversification-had more consistent returns (and fewer heart aches) than the others.

You can tell a similar story for U.S. versus international stocks, large companies versus small, etc. Two different stocks or sectors of the economy won't always be neatly "out of phase," of course. A graph of six to eight diverse stocks might show some that fluctuate in value very quickly, and others that fluctuate on a much longer cycle. In each group, some might fluctuate between very high and very low extremes and others by much less.

Overall, the effect is the same: a diversified portfolio, with positions in several areas of the economy, is less prone to being "all up" or "all down" at the same time. The portfolio "average" is more stable than its components. Diversification usually means smaller waves, calmer seas, and fewer investors who are queasily hanging onto the rail with their eyes shut.

So far we have looked at owning stocks in ones and twos, and carefully-picked handfuls. But the Dow Jones tracks thirty monster-sized stocks, and the "S&P" tracks 500. If you want a finger in that many pies, consider exchange-traded funds (ETFs), which treat a particular group of stocks (the Dow 30, say, or the NASDAQ 100) as if it were a single company (search a complete list of ShareBuilder Stocks).

With that possibility in mind, let's return to the idea that you only own one "stock" and are thinking about diversifying to two. But this time you own DIA (the Dow Jones index), so your weekly or monthly investment-however small-is spread evenly across those 30 bellwether stocks. What happens if you add QQQQ (the NASDAQ 100) as your second "stock"? Now, just half your investment is in the Dow 30-and the other half is spread across all the 100 large companies that make up the NASDAQ-100 index.

130 stocks. Now that's diversity! And you can increase diversity further by including a few companies that represent "off-index" sectors: your bank, perhaps, a solid pharmaceutical, or a non-U.S. company you favor. Or, for super-diversification, there are over 200 other ETFs to choose from.

Diversification is very, very important, so bear with us while we throw one more chart at you. It's impossible to eliminate all risk, because it's possible for the whole economy to do badly for a time. Call this "systematic" risk, and there's no getting away from it. But what you can control is the "unsystematic" risk-the risk penalty you pay for not being diversified. Broadly speaking, the more stocks you own, the lower your unsystematic risk tends to be over time.

Those who ride the crests fall in the troughs. It's cold and wet in those troughs-and investing should be as unlike surfing as possible. Think of diversification as the investor's equivalent of trading in the surfboard for a nice big boat.