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) and Yahoo! (YHOO) -- 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) is a form of diversification because they own servers and software! They think that having Pfizer (PFE), Bristol-Myers Squibb (BMY) and Procter & Gamble (PG) makes them safe!
|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|
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