Like putting your seatbelt on when you climb into your car, having a diversified portfolio is increasingly seen by financial planners as a prerequisite to responsible investing.
But while most planners agree on diversification as a must-have in a well-order investment portfolio, there is a diversity of opinion -- and lots of permutations -- on what actually constitutes proper diversification.
However, if there is any single thing planners all agree on, it is this: Putting all your money into one stock or into a particularly hot industry is bad investing.
No matter how convinced you are of bright future of the company or sector you are enthused about, your risks of losing it all are far, far higher than if you had spread your dollars out prudently across various industries, countries and asset types.
"Don't put all your eggs in one basket is true.... Enron, Global Crossing -- must I go on?" said Jon Ten Haagen, founder and principal of Ten Haagen Financial Group in Huntington, N.Y. and a certified financial planner.
Definitions of diversification
Kirsty Peev, a CFP and the portfolio manager for Halpern Financial in the Washington, D.C. area, argues there should be two levels of diversification in an investment portfolio.
The overall portfolio should have holdings in all the significant asset classes across the board.
These should include "domestic and international equities, value and growth, small-, mid-, and large-cap equities, corporate and municipal bonds with a range of duration and risk, plus alternatives when appropriate," Peev noted.
"The proportion of each varies based on the investor's needs, but true diversification means exposure to a WIDE variety of asset classes," Peev said. "When one area zigs, the other zags."
But there also needs to be another layer of diversification within the portfolio itself, with "diversified mutual funds and ETFs" that "reshuffle when certain holdings no longer fit the criteria, keeping only the stocks or bonds that fit the fund's objective," Peev noted.
This strategy offers protection against the extreme losses that can come with a more volatile strategy, which, in turn, will position your portfolio to take better advantage of the upside.
"You may not experience the FULL gains of equities, but importantly, you will avoid the steep declines because other areas of the portfolio should counterbalance extreme moves in any one asset," Peev said.
Kimberly Foss, founder and president of Empyrion Wealth Management and a CFP, has put diversification at the center of her professional identity.
Everything she sends to clients -- and every blog post she writes -- includes the tagline: "Stay Diversified, Stay Your Course."
A portfolio should include "small- and large-capitalization, domestic and international, established and emerging markets, growth and value," Foss said.
The exact proportions, in turn, are dictated by the risk tolerance of the client and stage of life.
"In other words, diversification needs to be multidimensional in order to be most effective," Foss said.
But it's not all just about the right mix of small-cap and large-cap, stocks and bonds, planners say.
Scott Bishop, an executive vice president for financial planning and a partner at STA Wealth Management in Houston, said "having diversified strategies" is also important.
Sometimes clients will say they want, for example, a diversified portfolio of stocks that pay high dividends.
But this reliance on a single strategy -- dividend playing stocks -- could backfire badly, Bishop warned.
While dividend stocks can be a good buy, they can also run into trouble.
"Sometimes investors are chasing yield and bid up the stocks so that investors are paying too much for that yield...and if the dividends are cut (maybe due to company issues, a rise in debt service, or an overall recession) the stocks get slaughtered," Bishop said.
Ten Haagen, the financial planner on Long Island, said diversification in terms of the money managers who are running the funds in your portfolio is also crucial.
"It is not a bunch of various mutual funds. It is a diverse number of money managers going after various segments of the market," Ten Haagen said.
The perils of concentration
Still, while there are as many variations on what it means to have a truly diversified portfolio as there are planners, there is a general consensus among planners that putting all your eggs - or this case, stocks - in one basket can be risky indeed.
It's not all about the starry-eyed investor, either.
Sure, some investors may simply be head-over-heels about a particular company and its brilliant prospects.
But in other cases, someone with a large stock holding in a single company may be an executive with the firm who has worked there for decades, or a widow/widower of that executive, or other family member or relative.
Given this, a gentler, more gradual approach is often needed, combined with an effort to have the client understand the particular risks that come with having such a large amount of her or his portfolio invested in a single stock, planners said.
"The fact is that most of the time, they have that holding because of either loyalty or longevity -- to a longtime employer, to a family member who gifted it to them, or some other reason," Foss said.
"For clients who are "stuck" with large holdings in a single asset or asset type, the last thing you want to do is tell them, "We've got to sell this right now!" Foss noted.
Eric Walters, president and founder of SilverCrest Wealth Planning in the Denver area and a CFP, also recommends a more gradual approach.
Walters views a heavy investment in a single stock as a "challenge" to a client's investment goals and works either hedge it, sell it over time to manage the tax costs, or donate some or all of it to accomplish their charitable goals.
If the client is emotionally attached, Walters will reduce the holding "to an acceptable level (I define this as 5% or less of investable assets) and monitor it closely."
It's not just a large holding in a single stock that can trigger alarms, but also "concentrated portfolios" of 10-20 stocks, Walters noted, pointing out these portfolios have the potential to both do much better but also much worse.
Walters calls them "a foolish risk."
"It is foolish because it is not taking advantage of the free lunch of diversification," Walters said.
Editor's Note: This article has been updated.