Diversify to Control Risk

Editor's note: As a special bonus to TheStreet.com readers, we will be running an updated version of Jim Cramer's "Twenty-Five Rules of Investing," from his latest book, Real Money: Sane Investing in an Insane World.. Here's Rule 5.

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 Quote) and Yahoo!(YHOO Quote) -- if you had all your eggs in that sector, you got scrambled. Same with pharma in the last several 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 Quote), EMC(EMC Quote) and Microsoft(MSFT Quote) is a form of diversification because they own servers and software!

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

And no matter how much I may like oil stocks at any given moment, I can't countenance a portfolio made up of ExxonMobil(XOM Quote), Chesapeake Energy(CHK Quote) and Halliburton(HAL Quote).

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		6.	Do Your Homework
	7.	Don't Panic		8.	Buy Best-of-Breed
	9.	Defend Some Stocks		10.	Don't Bet on Bad Stocks
	11.	Own Fewer Names		12.	Cash Is for Winners
	13.	No Regrets		14.	Expect Corrections
	15.	Know Bonds		16.	Don't Subsidize Losers
	17.	No Room for Hope		18.	Be Flexible
	19.	Quit When Execs Do		20.	Patience Is a Virtue
	21.	Be a TV Critic		22.	When to Wait 30 Days
	23.	Beware the Hype		24.	Explain Your Picks
	25.	Find the Bull Market
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