NEW YORK (CNN/Money) -
Everyone pays lip service to the importance of diversification, but few investors really understand how to get the full benefit of mixing different types of assets. In fact, it's well worth reviewing the theory behind diversification because it's the one free lunch in investing.
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The basic idea behind diversification is simple enough. All investments have a long-term average rate of growth -- known as "alpha." Investments also bounce around a lot as the economic climate changes. That volatility is known as "beta."
As a broad generalization, the riskier investments are, the higher return they have to offer to attract investors.
The most successful investment portfolios, therefore, try to achieve the highest level of return for a given level of risk. Risk can be held to a minimum by combining investments that offset each other's volatility. By combining assets that zig and zag at different times, you're left with pure alpha, stripped of the random losses known as beta.
The key is selecting shares of companies that react in opposite ways to likely economic changes. A higher oil price that hurt oil-burning utilities, for instance, would help an oil and gas producer.
A sample mix
How many stocks does it take to achieve balance? Some experts say you need more than three dozen to eliminate so-called diversifiable risk. But others say you can get rid of most of that risk with fewer than 10 stocks.
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If you rely on fewer than 10 holdings, every one has to pull its own weight. So the trick is making sure that your stocks are as different as possible. Here's a mini-portfolio of nine stocks that's a good beginning.
Start with leading companies in five of America's top growth industries (for complete stats, click here to go to the Sivy 70 page). Here are five.
Microsoft in technology. The dominant producer of software for personal computers, Microsoft is expanding into a variety of related businesses, financed by the company's $50 billion-plus cash hoard.
Pfizer in pharmaceuticals. The world's greatest drug powerhouse after acquiring Pharmacia, Pfizer has one of the best pipelines of new drugs in the industry.
Citigroup in financial services. The largest U.S. banking company, Citigroup is also well diversified. The company's long-time chairman Sandy Weill has handed off the chief executive slot to Charles Prince, who has said he plans to focus on improving profitability rather than further dealmaking.
Viacom in entertainment. Advertising spending is coming back and Viacom, with CBS and cable channels like MTV and Nickelodeon, should be a prime beneficiary. Ad totals this year will benefit from the Super Bowl, the summer Olympics and the upcoming elections.
Procter & Gamble in consumer products. With a wide range of world-class brands -- from Tide to Pampers -- P&G is the ultimate consumer stock. The company is further enhancing its earnings by marketing over-the-counter versions of drugs such as Prilosec.
Then for balance, you can add four stocks that represent sectors with different economic exposure.
Alcoa in raw materials. The largest U.S. aluminum company, Alcoa is one of the few businesses in the raw materials sector that offers growth potential worthy of a growth stock, with earnings gains projected to average 12 percent annually over the next five years.
Anadarko Petroleum in energy. With more than three-quarters of its reserves in North America, Anadarko is a way to lock up secure oil and gas reserves. The stock trades at least 10 percent below the value of those reserves, and its P/E is below 13.
St. Joe in land development. This stock is not among the Sivy 70 because it's an asset play rather than a growth stock -- but the assets are spectacular. The company is a nearly pure play on Florida land, owning almost 3 percent of the state, with plenty of acreage along the Gulf of Mexico
Union Pacific in transportation. Transportation stocks typically recover after industrial companies do. The reason: As business picks up, demand rises for shipping raw materials to manufacturers and finished goods to consumers.
Michael Sivy is an editor-at-large for MONEY magazine. Sign up for free e-mail delivery every Tuesday and Thursday of Sivy on Stocks.
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