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.

Step two is focusing on what I can do: Dividend stocks

My preference is to buy companies that have impressive histories of increasing their dividends and yields that are historically high. I dig deeply into the companies I am considering and only buy when I believe the business is worth owning. Some of the stocks that have made the cut include Realty Income (NYSE: O), PepsiCo (NASDAQ: PEP), Black Hills (NYSE: BKH), and Enbridge (NYSE: ENB).

Stepping back, that's a real estate investment trust, a consumer staples giant, a regulated utility, and a North American pipeline giant. Because of my pooled investments, I don't worry too much about overlaps, but I also make sure to buy stocks across various industries. For example, I own several REITs, several consumer staples companies, and a couple of energy stocks and utilities. These are areas where income opportunities often arise, so I have to go where the dividends are, while still working to keep the portfolio spread across various sectors.

Notably, when I buy a stock, I invest a specific dollar amount. Basically, I have a position size that I want to build. Once I build to a full position, I don't add to it. That may limit my upside, but it also means my downside risk is limited.

What's also notable here is that I try to buy when a stock has a historically high yield. For example, despite a long and successful history, PepsiCo isn't currently performing very well as a business. I believe the Dividend King, with over 50 annual dividend increases, will get back on track. But Wall Street is downbeat on the stock, pushing the yield above 4%. It was an opportunistic purchase I was prepared to jump on because if I can't find something I want to buy, I'm happy to hold cash. Warren Buffett uses a similar approach, so I'm not going out on a limb here. And cash is the ultimate "safe" investment, though inflation erodes its value over time. Still, I usually have cash on hand because I prefer to be highly selective about which companies receive my capital.

The big takeaway is to know your limitations

Diversification is important, and it is fairly easy to do if you take the time to consider how many baskets you are capable of dealing with at one time. I know I can't do everything all at once, so I've outsourced aspects of my portfolio while continuing to do the things that I enjoy and believe I'm good at. This allows me to focus my energy where it is likely to produce the best results. And if I can't "find" an investment, I don't force myself to find one just to say I'm doing something. I only make a move when I have a strong conviction, knowing that cash is a safe-haven investment that provides me with material flexibility in both good markets and bad ones.

Reuben Gregg Brewer has positions in Black Hills, Enbridge, PepsiCo, and Realty Income. The Motley Fool has positions in and recommends Enbridge and Realty Income. The Motley Fool has a disclosure policy.