Search Jim Cramer's "Mad Money" trading recommendations using our exclusive "Mad Money" Stock Screener.
this program last aired Aug. 5, 2013.
NEW YORK (TheStreet) -- When you own stocks, you have to be humble, Jim Cramer said on "Mad Money" as he dedicated the entire show to preaching against what he called the worst sin of investing, arrogance.
When you're putting together a portfolio, there's one you can be sure of, said Cramer: At some point, something is going to go wrong. And when that happens, you need to be prepared. How do you get prepared? One word, diversification.
Cramer said that diversification is the single, most important concept in investing and the key to avoiding enormous losses. A properly diversified portfolio can handle just about anything, he said, and keeping you in the game is what "Mad Money" has always been about.
Diversification means no sector can account for more than 20% of your portfolio, Cramer explained. So if you own five stocks, that means only one technology name, one health care stock, one industrial and so on. Not sure if two stocks overlap? Err on the side of caution, Cramer said.
But beyond just preventing overlapping sectors, Cramer said that diversification means also owning stocks in five key areas, mainly a high-yielding dividend stock, a growth stock, a speculative stock, a foreign stock and something related to gold.
Why gold? Because gold acts as an insurance policy, a hedge against global chaos. Gold tends to go up when everything else goes down, he said, while at the same time, appreciating over the long term. The SPDR Gold Shares (GLD) exchange-traded fund remains a favorite if you're not able to buy gold bullion or gold coins.
When it comes to gold mining stocks, however, that's a whole other ballgame. Miners don't trade with the price of gold, explained Cramer, but with their own production output. That production can be hampered by everything from geopolitical issues to the weather, making the miners a far riskier investment than just investing in the commodity itself.
Cramer's next lesson for investors was that sometimes conventional wisdom is just plain wrong. He said for decades those "in the know" on Wall Street have been telling investors they must only invest the so-called blue-chip companies, those with the size and strength to provide stability for the long term.
But in recent years, the markets have turned the notion of blue-chip upside down with such notable names as Lehman Brothers, Washington Mutual and General Motors (GM) all filing for bankruptcy.
Cramer said that much of the traditional investing advice ignores the human elements of investing, those which tell us that investing in stodgy stocks that don't do much will only cause many investors to stop doing their homework or pay attention at all. That's why having at least one speculative stock in your portfolio is so important.
Cramer said he advocates having no fewer than five stocks in a portfolio, but also no more than 10 since that's about all the time the average home-gamer will have to spend on their investments. But one of those stocks needs to be a speculative stock -- a high-risk, high reward company that will keep you interested and paying attention and one that just might provide massive returns.
One type of speculation involves those companies with shares prices in the single digits, Cramer explained. He said that sometimes, great companies fall onto hard times, as did Ford Motor (F), Bank of America (BAC), Pier 1 Imports (PIR) and Sprint (S).
But when a share price falls below $10, many mutual funds and institutional investors simply cannot own them, said Cramer, which means that investors who can tell when a company's fundamentals have changed can buy in ahead of the big money for huge gains once shares regain double-digit status. That was certainly the case with all four of the names above, Cramer said. In each case, speculative investors could've played the "over $10" jump ahead of the big money players.
Go For Growth
The next type of stock in a properly diversified portfolio is a growth stock, said Cramer. He said every stock needs a secular grower, one that's on the rise no matter what the economy is doing at the time. Stocks like Chipotle Mexican Grill (CMG), Apple (AAPL) and Panera Bread (PNRA) all fit into this type of stock.
How should investors gauge these red-hot stocks with seemingly unbridled share prices? Cramer said he's always willing to pay a multiple that's up to twice a company's growth rate. So for a company growing its earnings at 20% a year, Cramer said he's willing to pay up to 40 times earnings for it.
Investors must pay close attention to which way a growth company's earnings are headed, however. These high fliers can seem to soar endlessly if earnings are accelerating and analysts are scrambling to raise their estimates to fit that growth. But as soon as earnings slip and those estimates are not met, the downward gravitational pull can cause shares to take a pounding.
This was certainly the case with Apple throughout much of 2012 and 2013, said Cramer, and the same can be said for Chipotle, BlackBerry (BBRY), Nokia (NOK) and Chipotle. When you see multiples compress, be prepared for a bumpy ride, Cramer concluded.
Unsexy Dividend Stocks
Cramer's next class of stock for a properly diversified portfolio is one that offers a high dividend yield. He said that while dividend stocks may not be as sexy as a high-growth name or a speculative stock, buying a high-yielding stock and reinvesting those dividends remains one of the best ways to make money, period. Since 1926, nearly 40% of the return from the S&P 500 has come from dividends, Cramer noted, so investors who ignore dividends ignore a huge chunk of earnings potential.
Why are dividend stocks such a good investment? Cramer said it's because a big dividend offers a cushion that helps prevent stocks in a big decline. As share prices fall, yields rise, eventually to a level where investors simply cannot say no. This trend prevents stocks with long histories of steady dividends and dividend raises from falling much below where their yields reach 4%. At that level, there always seems to be hoards of investors buying in.
Beware of stocks that have yields that are too high, however, Cramer cautioned. He said that in addition to a solid track record of paying and raising their dividends, investors need to see earnings that are at least twice the dividend payout to deem it a "safe" dividend. This rule can be broken for companies that have large capital investments and, therefore, large depreciation expenses, Cramer noted, as depreciation is not an expense that directly affects a company's cash flow.
Cramer's final word about dividend stocks is nomenclature. He said dividend stocks have a lot of dates, but the only date investors should be concerned with is what he dubs the "must own" date, which is the day before the ex-date, or ex-dividend date. The must-own date is the date that investors must own shares in order to receive the next dividend payment.
A Foreign Affair
Cramer's last piece of his diversified puzzle was owning a stock that has some foreign exposure. He said a U.S. company that does business overseas is no longer enough in our increasingly global world, investors must own a truly global company. The U.S. is often the caboose in the global economic love train, Cramer quipped, with China acting as the locomotive and Latin America, India and even Germany following close behind.
Investors needn't speculate on an exotic Chinese or Brazilian company in order to get their foreign exposure, however. Cramer said an investment a lot closer to home will suffice. He said Canada has one of the healthiest economies in the world and Mexico offers a fast-growing economy with low inflation as well. Baskets of European stocks are also a great way to play international markets.
To watch replays of Cramer's video segments, visit the Mad Money page on CNBC.
-- Written by Scott Rutt in Washington, D.C.
To email Scott about this article, click here: Scott Rutt