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There are some things so entrenched in our culture that we never stop to think what they really mean. Let me direct you to one of the most striking examples in the last 10 years: The Backstreet Boys hit, I Want It That Way. This god damn song is so catchy that, while we were all singing along and bopping our heads, we never stopped to think about what the lyrics actually meant. Consider:

Tell me why

Aint nothin but a heartache

Tell me why

Aint nothin but a mistake

Tell me why

I never wanna hear you say

I want it that way

Now I am an educated man, but I cant find any deep meaning in those (admittedly soulful) lyrics. To be honest, I dont understand what the hell they mean. But I keep repeating the words because the beat is so good.

A pretty similar thing has happened with the phrase diversify your portfolio. We all say it, but why is it really important? And how do you actually do it?

Why diversification is important

Diversification means not investing everything you have in one area. For example, if you put all your money in one stock, or all in technology stocks, or even all in real estate, youre not diversified.

Its important to be diversified because if that stock does down (lets say down 20% or even bankrupt), all of your money could be wiped out. But Ramit, you might say, thats good advice, but I own stock in a big company. I doubt theyd go down 20% all of a sudden.

I would respond to that in 2 ways: First, I would bet you a nice dinner that you were wrong. See, I like to make bets that Im sure Ill win. Second, Id point out Ebays stock in January 05. Ebay is a huge company with a

$47 billion market cap, but when it reported that it missed Wall Street expectations by a pennythats right, one penny its stock dropped nearly 20% in one day.

finance.yahoo.com

Some restaurants I enjoy: Taco Bell, Applewood pizza, Indian food, and Thai food.

Diversification is also important because, with all due respect, youre not that smart. Dont worry, neither am I. Hell, nobody is. Why do you think so many people lost their money in the dot-com bust? I remember overhearing one elderly couple at the mall a few years ago; the husband was basically explaining that he was diversified because hed invested in 5 different companies that werewait for itCisco, Microsoft, Amazon, EBay, Symantec, and something else I dont remember. Listen, you can invest in 200 stocks, but if theyre all in the same sector, youre not truly diversified.

One final point: A lot of people think that, because they own a mutual fund, theyre automatically diversified. This is sort of true, but not really at all. Check it: There are tons of types of mutual funds including sector funds, which invest in certain sectors. If you want to own a bunch of biotech stocks, for example, you could buy a sector fund focusing on biotech. The implication is clear: If biotech does poorly as an entire sectormaybe the government levies regulatory pressure on development or scientists suffer one setback after anotherinvestors may pull out and the entire sector will go down in value. As a result, so will your money. Just because you own a mutual fund, youre not automatically diversified.

The second concern with mutual funds is that some people own more than one, and the stock holdings might be duplicated, leading to less diversification than you think. Lets say you own a small-cap mutual fund, a technology fund, and a growth fund. Those three funds could all hold the same stock; if it performed poorly, it could have a disproportionately negative influence on your holdings.

The implications of diversification

True diversification protects you from loss because, even if one your investment holdings completely tanks, it wont drag down the rest of your portfolio. But diversification also limits your potential upside: If one of your stocks jumps 500% (but its only 10% of your portfolio), it wont take your portfolio up that much.

This is a tradeoff youll have to carefully consider. A couple of points might help: We are more motivated by loss avoidance than by potential gain. In other words, wed rather not play a game in which we might lose 50% even if we had the potential to gain 200%. Also, even though its true that you limit your potential upside by diversifying, if you pick good investments and hold them for a long time. you can expect substantial returns.

How to diversify

A few months ago, I was talking about finance stuff with one of my friends whos actually a pretty sophisticated investor. When I asked him how many stocks he owned, he told me that he held 20. I asked him 2 questions: What the hell are you wearing? Seriously, he had a ridiculous outfit on and I was embarrassed to be seen next to him. But then I asked him why he owned so many stocks.

Diversification, he told me. Now lets keep it real. Owning 20 stocks is stupid and I told him so. You simply cant focus on 20 investments (tracking, reading the prospectuses, comparing them to their peers, etc). Also, with 20 stocks, even if one stock goes up 10,000%, its such a negligible part of your portfolio that youll hardly realize any gain.

I recommended that he pick his best 5 stocks, sell the rest, and think carefully about where to put the moneyeither back into his select 5 stocks or an index fund (or both).

You can start diversifying by deciding which investments youre going to make (see All About Stocks and Bonds and All About Mutual Funds to start off). Also note that there are other investments besides these two areas but stocks/funds are excellent starting points. Remember, you can diversify by sector (e.g. retail vs. technology), size (e.g. small-cap vs. large cap) strategy (e.g. growth vs. income).

If you already own mutual funds, you can use a mutual fund screener to make sure your funds dont have too much overlap.

Then decide how much of your portfolio you want each investment to beand rebalance at the end of every year (for example, if one stock jumps up 5,000%, it probably now holds a higher percentage of your portfolio and you may want to adjust accordingly). Finally, if you lost that bet with me at the beginning of this article, you can take me out to dinner. Mondays and Wednesdays are good for me.