'Is my stock portfolio truly diversified?'

NEW YORK (Money) -- I've split my stock portfolio among three different funds characterized as "growth," "tech" and "index." How can I tell whether my stock holdings are truly diversified? -- Matthew B., St. Louis, Missouri

I'm glad you've asked this question because diversification in an investment sense is often misunderstood and sometimes abused.

For example, lots of people convince themselves they're getting into silver, energy, emerging markets or whatever because they're "diversifying," when in reality they're just buying into investments that been generating the most buzz.

But for your stock portfolio to be considered truly well-rounded -- as opposed to a collection of what's been hot lately -- you take a bigger-picture view and assure that it's diversified on a number of fronts.

In terms of investing "style," for example, you want to have both growth stocks (ones consistently churning out rapidly growing earnings) and value shares (companies that are underpriced relative to profit potential or value of their assets) represented among your holdings.

The same concept applies to size -- that is, your portfolio should contain large and small companies, as well as mid-sized ones. And, of course, you want a good range of industry groups to be represented, everything from basic materials, consumer goods and financials to health care, industrials and technology.

You can argue about how your portfolio ought to be divvied up among these various categories. But the point is that you want to spread your money around. As this chart shows, predicting how specific sectors will do year to year is an iffy proposition at best.

And if you concentrate all or most of your money -- whether intentionally or not -- into a few areas that end up faring poorly, you could seriously sabotage your portfolio's growth.

If you invest in individual stocks, achieving a reasonable balance is relatively straightforward. Assuming you know what you're doing -- and if you don't, why are picking stocks at all? -- you should be aware of the characteristics of the companies you're buying and which industry and style groups they fit into.

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Building a diversified portfolio then largely comes down to taking the time and effort to be sure you've got different sizes, industries and styles represented.

Things can get a little trickier, however, when you're dealing with mutual funds. One reason is that a fund's name often doesn't give you a very precise idea of what it owns. What exactly is an equity-income fund, for example?

And even in cases where you'd figure a label should clarify things, it can still leave lots of gray area. You note, for example, that one of your funds is characterized as "growth." Okay, but does it home in mostly on large growth stocks, small fry or something in between? And how does it define growth?

Even if you own several funds whose varying names suggest your portfolio is diversified, you could still have plenty of overlap. In your case, for example, it wouldn't be a stretch for your growth fund to own many of the same companies as your tech fund, since tech stocks are typically growth stocks. And depending on what type of index fund you own, it could very well own many of the shares that are also in your growth and tech stocks.

So how can you get a sense of how diversified (or concentrated) your stock holdings actually are? The easiest way is to plug the ticker symbols for all your funds into Morningstar's Portfolio X-Ray tool (which is available free, with registration, in the Tools & Resources section of T. Rowe Price's site).

Once you do that, you can look at your portfolio from a variety of dimensions. (If your portfolio contains bonds, they'll show up in the analysis too.) If you choose the "X-Ray Overview" tab, for example, you'll not only see how your portfolio overall -- that is, the stocks of all your funds combined -- breaks down among 11 different industry groups.

You'll also see how the percentage of assets you have in each industry sector compares with the stock market overall as represented by the Standard & Poor's 500 index.

By looking at the "Stock Style Diversification" grid on the same page, you'll see how your stock holdings overall divvy up by both size (large, medium and small) and by style (value, growth and what Morningstar calls "core", essentially a blend of value and growth).

The grid doesn't tell you how your portfolio compares to the overall market on size and style, but you can easily find out by checking out the holdings style box for Vanguard's S&P 500 index fund.

Scroll down a bit, and you'll also get a number of stats on your portfolio, including the price/earnings and price/book ratios of your stock holdings overall and how those ratios compare to the S&P 500.

Click on the "Stock Intersection" tab, on the other hand, and you'll see which stocks your various funds hold in common, as well as what percentage of each fund and your entire portfolio those stocks represent.

Or to put it another way, you'll see how much overlap, if any, in specific stocks there is among your funds. In short, by plugging in your funds and doing a little clicking around, you'll be able to get a very good sense of what your portfolio looks like as a whole, and in particular whether it's diversified or overly concentrated into one or two sectors or styles.

Of course, since neither your funds nor all the stocks they own will earn the same returns, you'll have to re-do this process periodically -- say, once a year -- to prevent your portfolio's proportions from getting too out of whack.

As I mentioned earlier, people can disagree about what constitutes the "right" proportions -- that is, how much should be in value shares vs. growth, large stocks vs. small, what percentages should go into different industries.

Send Walter Updegrave a question

I'd argue that you should adhere pretty closely to the market proportions, as they represent the consensus of investors overall. If you want to tilt your portfolio toward a certain direction -- more growth, less value, a higher percentage in certain industries, or whatever -- that's fine.

But you should have a good reason for doing so, and that you run the risk that your portfolio may not do as well as the market overall.

If all this seems like too much work, there's a much simpler way to go: Stick to broad-based indexed funds. If you invest in a total U.S. stock market index fund, you'll get virtually all publicly traded U.S. stocks in the exact proportion each company's market value represents in the stock market overall. Which means your U.S. stock holdings will be truly diversified by industry sector, size and style.

And it will stay that way without you having to do a thing. A total U.S. bond market index fund can do the same for the taxable bond market. In short, by combining just two funds you can have a fully diversified domestic portfolio.

If you want to add international exposure, you can throw in a total foreign stock market index fund. You can find such index funds -- or ETFs, if you prefer to use them instead of funds -- on our MONEY 70 list of recommended funds.

But whether you go the simple index-fund route I've just described or you prefer to build a portfolio using other types of funds, the point is that you want to be sure your holdings are reasonably balanced. Because a lopsided portfolio can lead to lopsided results.