Portfolio Diversification Is the Simplest Way to Lower Risk. Here's How I Build Mine.

To summarize my investment approach, I prefer to buy companies with long histories of dividend increases and historically high yields. Those two traits don't come around all that often, and sometimes I find clusters of stocks in specific sectors. I need to think specifically about diversification, one of the simplest and most effective ways to reduce risk. Here's how I've done it as I've built my portfolio of around 34 investments.

How many stocks do you need to be diversified?

The Motley Fool recommends that investors own 50 stocks. That's a perfectly fine number, but also a lot of work. And just owning 50 stocks doesn't actually mean you are diversified. You could own 50 technology stocks, for example, which would leave you with exposure to just a single sector. That's not diversification. Diversification is really about owning a reasonable number of investments across a wide range of sectors and asset classes.

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My first step toward diversification was to take an honest look at what I want to achieve and what I'm capable of. My goal is a mixture of income and capital appreciation. I am fairly confident in my ability to select dividend stocks, though every investor makes mistakes from time to time, and I know I can only juggle so many stocks at once. In other words, 50 stocks are too many for me, so a core part of my diversification strategy is to outsource some of my work.

For example, I own two Baron mutual funds to gain exposure to growth stocks and smaller companies. I own several closed-end funds: one focused on healthcare stocks with an option income overlay, one investing in convertible securities, and one with a broadly diversified dividend portfolio. And I own three exchange-traded funds: one with an option income focus and two that use very different screening approaches to pick dividend stocks.

This collection of investments includes hundreds of stocks across a wide range of sectors (and convertible bonds), materially adding to my diversification. And many of these pooled investments do things I either don't want to do myself because they are time-consuming (such as an option income strategy) or don't think I can reasonably do myself (such as investing in healthcare and small growth stocks). With my foundation spread widely across sectors, investment approaches, and a large number of stocks and convertible bonds, I can comfortably invest in individual stocks knowing I have a diversified foundation to work from.