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Rule No. 5: Diversify to Control Risk

Editor's note: Jim Cramer's new book, Real Money: Sane Investing in an Insane World , is available in selected bookstores now. As a special bonus to RealMoney readers, we will be running Cramer's "Twenty-Five Rules of Investing." For more about the new book and to order it, click here . Today, we present Cramer's fifth rule of investing. To read about his first rule, click here ; for his second, click here ; for his third, click here ; for his fourth, click here .


If you control the downside, the upside will take care of itself. I have always believed that to be the case. But controlling the downside means managing the risk.

The biggest risk out there is sector risk. I don't care how great a tech stock was in 2000 -- even eBay (EBAY - Get Report) and Yahoo! (YHOO - Get Report) -- if you had all your eggs in that sector, you got scrambled. Same with pharma in the last three years. Or oil in 1982, when I broke into the business.

What can keep you from getting nailed by sector risk, which is about 50% of the entire risk of owning a stock?

Diversification.

It's the only investment concept that truly works for everyone. If you can mix up enough different sectors in your portfolio, you can't be hit by one of the myriad perfect storms that come our way far more often than you would think.

Why aren't more people diversified? Many amateurs don't know the stocks they buy. They end up with stocks that are frighteningly similar. When I started playing "Am I Diversified" on my radio show in 2001, I was blown away by how few people knew just how undiversified they really were.

I still field quite a few calls from people who genuinely think that owning Sun Microsystems (SUNW), EMC (EMC) and Microsoft (MSFT - Get Report) is a form of diversification because they own servers and software!

They think that having Pfizer (PFE - Get Report), Bristol-Myers Squibb (BMY) and Procter & Gamble (PG) makes them safe!

And as much as I like the oil stocks, I can't countenance a portfolio made up of ExxonMobil (XOM - Get Report), Chesapeake Energy (CHK) and Halliburton (HAL).

An undiversified portfolio is not just an amateur mistake, though. Many professionals don't like to be diversified because of the bizarre way money is run in this country. If you concentrate all your bets in one sector and the sector takes off, you will beat pretty much every diversified fund out there. That's the nature of the beast. You then can market yourself as a huge success and get profiled by every magazine and take in capital from unsuspecting folk who don't know how much risk you truly are taking on.

Both amateur and professional are wrong; controlling risk is the key to long-term rewards and controlling risk means being diversified at all times.

1. Pigs Get Slaughtered 2. It's OK to Pay the Taxes
3. Don't Buy All at Once 4. Buy Damaged Stocks
5. Diversify to Control Risk
Check back for more of Cramer's Rules
At the time of publication, Cramer was long Yahoo! and Halliburton.

James J. Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for Action Alerts PLUS . While he cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to jjcletters@thestreet.com. Listen to Cramer's RealMoney Radio show on your computer; just click here . Watch Cramer on "Mad Money" at 6 p.m. EST weeknights on CNBC. Click here to order Cramer's latest book, "Real Money: Sane Investing in an Insane World," click here to get his second book, "You Got Screwed!" and click here to order Cramer's autobiography, "Confessions of a Street Addict."

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