Beginner's Guide to Diversification

Editor's note: This is a special excerpt from TheStreet.com Ratings' Ultimate Guided Tour of Stock Investing. Other Beginner's Guides cover stock basics and market indices.

Remember, when you're on safari, you've got to pay attention to the clues. Many beginning investors, unfortunately, get so dazzled by the glitter of the stock market that they lose sight of the trees in the midst of the jungle. We'd like to tell you what happened to one beginning investor -- and how to avoid repeating his mistake.

John, a 38-year-old accountant, decided to go into the investing jungle without a guide. He was good at crunching numbers at work, and if he applied that same skill to investing in the stock market, he'd have a chance to win big. After all, a lot of other professionals he knew had made a few bucks in the market.

This was a few years ago, when the stock market began its dizzying ride to the top of what looked like an endless blue sky without a cloud in sight. John jumped in with both feet. After sharing his dream of a summer home with his wife, he took his life savings and sank it into a few carefully chosen technology stocks. He had crunched the numbers, done his research ... everything looked good.

Unfortunately, his family's dreams were shattered when the stocks hit rock bottom, wiping out all of his hard-earned savings in the blink of an eye.

What did John do wrong? What happened?

He didn't follow one very critical rule of investing: diversification . You balance your risk by diversifying and buying stocks in different sectors or industries. Sectors can be sliced and diced in many different ways. We slice our stocks into 10 different sectors. A few of the popular ones are technology, health care and financial services. John's mistake was buying too much of one sector. Here is a list of sectors:

Sectors:

• Consumer discretionary
• Consumer staples
• Energy
• Financial services
• Health care
• Industrials
• Information technology
• Materials
• Telecommunications
• Services
• Utilities

Like too many investors, he believed the hype: nothing but blue skies with those fast-moving tech stocks! But the reality was, when tech stocks fell rapidly, he, and a lot of other investors at the time [2000 through 2002], got washed out by some unexpected storm clouds.

To stay dry, John should have better understood the risk/reward trade-off. In other words, he didn't recognize that all his buddies who were making lots of money investing in tech stocks were also taking on huge amounts of risk. Obviously, more risk than he was prepared to handle. How is risk defined? Risk is the likelihood that a stock's price will go down. The riskier the stock, the more chance it will decrease in price.

An exchange-traded fund (ETF) that tracks the performance of technology companies in the S&P 500 is the Technology Select Sector SPDR ("Spider") (XLK Quote). To learn more about ETF investing, visit TheStreet.com ETF Center.