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

 

 

Diversify to Control Risk

 

 

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 - news) and Yahoo! (YHOO - news) — 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 - news), EMC (EMC - news) and Microsoft (MSFT - news) is a form of diversification because they own servers and software!

They think that having Pfizer (PFE - news), Bristol-Myers Squibb (BMY - news) and Procter & Gamble (PG - news) 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 - news), Chesapeake Energy (CHK - news) and Halliburton (HAL - news).

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.

 

At the time of publication, Cramer was long Halliburton and Microsoft.

Jim 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. Watch Cramer on Mad Money at 6 p.m. & 11p.m. ET weeknights on CNBC. Click here to order any of Jim Cramer’s books including his latest endeavor Stay Mad For Life:  Get Rich, Stay Rich (Make Your Kids Even Richer). While he cannot provide personalized investment advice or recommendations, he invites you to send comments on his column by clicking here.

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