(MONEY Magazine) – Harold Evensky may be the best financial planner in the country. He is almost certainly the best known--a ubiquitous guy with a bow tie and a big brain who can effortlessly explain the mathematical complexities of investment theory. He's also living proof that it's a lot easier to talk about a diversified portfolio of mutual funds than it is to build one. Every three months, the New York Times asks Evensky and four other experts to pick a basket of mutual funds, then compares their results to the return of Standard & Poor's 500-stock index. Since March, Evensky's Times portfolio has included Schwab 1000, an index fund of the 1,000 largest U.S. stocks; Vanguard Index Value, an index fund that owns the cheapest stocks in the S&P 500; and Wilshire Target Large Company Growth, a third index fund that holds the fastest-growing members of the S&P 500.

These three funds are all stalwarts, but owning them together makes no sense--as Evensky now readily concedes. That's because at last count, 324 of the 364 stocks in the Vanguard fund and 214 of the 227 in the Wilshire fund are included in Schwab 1000. In other words, 89% of the stocks in the Vanguard fund and 94% of Wilshire's are already in Schwab's. "There's a huge overlap," Evensky tells me a little sheepishly. "I sort of backed into it over time. It's not a perfectly intelligent and straightforward portfolio."

He hastens to add that he does not use this combination of funds for his real clients. But if a renowned expert like Evensky can make a mistake like this, you know the rest of us can too. It's a good reminder that we all need new and better ways to think about diversifying our portfolios. That's especially urgent because diversification is just about the only tenet of modern finance that has proved to be unassailably true. No one disputes that diversification works, because, at heart, it's simply common sense codified. The intricate mathematics underpinning the theory of diversification can be boiled down to a simple cliche: "Don't put all your eggs in one basket." By selecting investments that go up and down at different times--rather than just seeking investments with the highest raw returns--you can raise your overall rate of return while lowering your risk. In the world of investing, that's as close as you can get, other than 401(k) matching, to a free lunch.

But even though it's all common sense, fund investors tend to make two serious errors when they try to diversify. First, they forget that their funds need to complement all their investments. Second, they fail to check, when buying a new fund, how much it overlaps with those funds they already own.

YOU ARE AN EGG

For diversification to work its magic, you need to consider all the sources of risk and return in your total portfolio. And your portfolio does not consist only of investments in mutual funds, stocks, bonds and cash. If you're like most people, the single biggest investment in your portfolio is you. That's because your career is an asset--and your total labor income, from now until the day you retire, constitutes the return on that asset.

Economists call this your "human capital," and you need to make certain that it harmonizes with your investment capital. Mike Henkel, president of Chicago's Ibbotson Associates, the leading investment consulting firm, explains it this way: "If you're 30, you have probably got 35 years of labor income ahead of you. You've got a big chunk of your total portfolio tied up in your own human capital. So it's important for you to have a very well diversified invesment portfolio."

If, for instance, you work as a software engineer in Silicon Valley, your human capital is dependent on the health of the technology industry: A recession in the computer business (like the one that hit in 1983-84) would not only cripple your salary growth, it might also throw you out of work entirely. The recession could last months or years. Even the value of your house might drop. That's just when you'd want your investments to be there for you--but if you were paid partly with options on your company's stock, and you allocated much of your 401(k) into company stock, and you even bought a technology mutual fund to boot, then your investments will be down at the same time you are.

"There are great illiquidities to changing your job or profession, especially when your industry is in trouble," says Harry Markowitz, who won the 1990 Nobel Prize in economics for his pioneering work on diversification. "So it's desirable to choose an investment portfolio whose returns are not too highly correlated with your own personal income."

William Sharpe, who shared the 1990 Nobel Prize with Markowitz, says, "I would avoid a knee-jerk response like, 'I work in banking--so God forbid I own any bank stocks.' But you should certainly think hard about how much human-capital risk you're bearing."

In short, when you're making sure not to put all your eggs in the same basket, remember to count yourself among the eggs. Timothy Kochis, a financial planner at Kochis Fitz Wealth Management in San Francisco, says, "If you work for a very large company like GM or IBM, we may recommend that you begin investing more heavily in small stocks. If your company does most of its business in the U.S., we'll suggest you add some international stocks to your portfolio."

By the same token, says Kochis, you should think twice about buying a real estate fund if you already own a home. After all, he points out, that means your house is already a large part of your net worth. Do you really need to own even more real estate?

The table below, which shows the correlation between stock returns in 10 major industries over the past 10 years, will help you mix and match investments. Let's say you work in the home-building industry. By running your eye across the row labeled "Home building," you can see that banking stocks have had a fairly high correlation with yours (0.58), while oil-industry stocks have had a very low correlation (0.13). (The lower the number, the less similar the returns and the more effective the diversification.)

If you think about it, this makes sense: Since new homes are financed with the mortgages that banks provide, those two industries should prosper when inflation is low and borrowing is cheap. But when inflation is high, both industries will suffer. On the other hand, oil companies tend to prosper when inflation is high, and that should make oil stocks a pretty good diversification tool for you. (An interactive version of this table, showing cross-correlations of more than 60 industries, is available online at www.money.com.)

Of course, this table doesn't provide all the answers. For example, gold-mining stocks (not shown here) have had very low correlations with almost anything you could think of, but they've had abysmally bad returns. Tobacco stocks have also behaved unlike those in most other industries, but you might have moral objections to them. And over time the stocks in some industries may become more closely correlated. My point in showing you this table is simply to encourage you to think about your portfolio in innovative ways.

WHEN TWO FUNDS ARE WORSE THAN ONE

Now let's tackle the second big problem in diversifying a fund portfolio: overlapping holdings. What's wrong with owning funds that overlap? Let's say you own Vanguard Specialized Health Care and you're thinking of pairing it with T. Rowe Price Blue Chip Growth (as a recent SmartMoney article suggested). Not only do both these funds count Pfizer, Warner-Lambert and Bristol-Myers Squibb among their top 10 holdings, but Blue Chip Growth has 20% more of its assets in health-care stocks than does the market as a whole.

Thus, instead of complementing the Vanguard fund, Blue Chip Growth throws it out of kilter. Remember, the whole point of diversification is to produce the highest possible return at the lowest possible risk. By making a double bet on health care, you've certainly increased your potential return if those stocks do well--but you've done nothing to reduce your risk if they fare poorly. What's more, you're paying two management fees at once.

If you want to bet on the promising future of health care, then by all means keep the Vanguard fund--but play it off against a diversified pick that, unlike Blue Chip Growth, won't give you a health-care overdose. At T. Rowe Price, both Equity-Income and New America Growth own substantially fewer health-care stocks than the market as a whole.

When buying a new fund, don't make the classic mistake of looking only at its performance. Instead, check to see what it owns and whether those holdings duplicate what you already have. You can get a rough idea of how much your funds overlap by eyeballing their annual and semiannual reports. Look at the tables of their 10 largest holdings, then note how much they have in each industry sector (see the "schedule of portfolio investments"). If they share three or more top holdings or their biggest industry weightings are within a couple percentage points of each other, you've got an overlap problem.

Of course, this is not terribly scientific. William Chennault, a college computer administrator in Kansas City, Kans. who has been an avid fund investor for years, got so frustrated with his inability to tell how much his funds had in common that he invented a software program called Overlap. Now available on CD-ROM ($48 per CD, or $150 for a one-year subscription; 800-OVERLAP), the program compares any stock fund with any other, calculating how much of their assets are invested alike. (A similar service is available free on the Internet at www.findafund.com, but in my opinion, Overlap is a bit more comprehensive and easier to use.)

The program isn't perfect. It can't tell you whether the overlap between two funds comes from lots of stocks held in common or just a few. It does not count cash or bonds, so a fund with only 70% of assets in stocks will show a maximum overlap of 70% with any other fund, even if they own the identical companies. But if you own both Phoenix Growth & Income and American Century Income & Growth, for example, Overlap reveals that they have a hair-raising 63% of their assets invested in the same stocks.

If you need to weed out any redundant funds, it's a good idea to do so before they make their year-end taxable gains distributions. That makes this the perfect time of year to give yourself an overlap checkup. While you're at it, make sure your fund investments are a good match for your investment in yourself.

HOW TO BUILD A FUND PORTFOLIO Live conference with Money's Jason Zweig, Monday, Sept. 28, at 5 p.m. ET on the World Wide Web at chat.yahoo.com