Cramer says diversification is the only free lunch. I agree, diversification is a necessity and is very easy to accomplish. In 1999-2000 people bought Dell, Microsoft, AOL and Cisco and thought they were diversified. The tech sector crashed in 2000 and all their stocks dropped in value. The best way to protect against sector downturns is to diversify. One should also try and diversify such that market cycle do not affect their complete portfolio. Say I diversify my holdings into companies involved in Basic Industry, Energy and Precious Metals. Since all three industries tend to perform well at the top of a bull market and do poorly at the bottom my portfolio is vulnerable to an economic/stock market cycle.

To avoid diversification mistakes and to provide a guide I came up with a wheel. The diversification wheel is not meant as a recommendation of any sector or stock. It is just a quick tool to look at which industries/sectors are similar enough that they may be affected by a sector downturn or the economic cycle.

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Click here for the full sized image

To use the wheel click the link above for the full sized image and print it out. You can use the wheel to judge if you are diversified by marking your top holdings on it.

Diversified: If your stocks are in sectors that are roughly spread out equally around the wheel then you are diversified.

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Vulnerable to sector downturn: If the sectors are very close to one another you may be vulnerable to a sector downturn.

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Vulnerable to market/economic cycle: If the sectors are concentrated in one half of the wheel you may be vulnerable to an market/economic cycle.

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Pick a stock to diversify: Mark your existing stock picks. The centre of the section on the wheel which is missing from your portfolio would probably make a good addition to help diversify your portfolio.

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The Wheel is a work in progress, any suggestions for improvements to the wheel are welcome and I will try to incorporate them.