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True Diversification Enhances Portfolio Return

Years ago, my husband and I worked for the same global-investment-management firm in the same West Coast office. One day, the decision was made to close that office and move our team across country to New York City.

We didn't want to move but because we both worked for the same firm, we didn't exactly have a choice. Had we diversified our employment and, therefore, our primary source of income, we would have put ourselves in a much stronger position to make the best decision for our family.

We ignored the cardinal rule of investing: diversify, diversify, diversify.

But rarely do investors understand what it means to be truly diversified. Simply owning shares in various companies will not provide real diversification if, for example, those companies are all in the same industry or economic sector. Diversification is actually about how different investments perform in various economic scenarios. Or to put it another way: Selecting investments is not so different from how we select our friends.

Each one of my friends exhibits an overriding attribute. Some are great in a crisis. Others are fun to be around when times are good. I have friends who like to exercise and those who prefer the theater. Supportive friends and the kind who are scarce in times of difficulty. Like you, I have different friends who shine in different seasons. The same is true of stocks — certain stocks do well when the economy is thriving and others outperform when the economy is soft.

Proper diversification requires selecting stocks from most (if not all) of the 10 major economic sectors: consumer discretionary (luxury items and entertainment), consumer staples (soap and necessary food items), energy, financials, health care, industrials, information technology, materials, telecommunication services and utilities. Each of these sectors generates strong performance under different economic conditions. Let's look at two real-life examples.

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