Welcome to our Club Portfolio Clinic! Over the next week or so, I'll be reviewing some club portfolios to see if we can't identify areas where those portfolios might possibly be improved.

But first, I'd like to cover the basics of building a portfolio as I see them. (Some of the following text has been excerpted and adapted from my book, The Complete Idio

A stock is a stock--but a portfolio is where the real money is! Even the name "portfolio" suggests the idea of power and wealth. Your father or grandfather may have had a portfolio of genuine, thick, well-worn leather, stuffed with ledgers and account statements and other important documents. Within this portfolio would have been meticulous records of all the investments he had made, row after row of numbers and calculations.

Today, a portfolio refers to any group of investments that you can make. You can consider all your stocks as one big portfolio, or you can group your investments by the different goals you're trying to achieve. If you've decided to invest in the stock market, it's a good idea to pay attention to all the stocks you own and what happens to your risk and return when they all come together.

Diversify, Diversify, Diversify

When you build a portfolio of stocks, it's very important to consider the diversification of your holdings. Diversification is the process of spreading out your investments so that you decrease risk as much as you can while still maintaining an acceptable rate of return.

One of the fundamental truths about stocks is that their share prices will fluctuate. Even if you're "right" about a particular stock you've picked, you might not be right at the right time.

Stock prices rise and decline for manylots of reasons, often through no fault of the company at all. The overall status of the economy, the condition of a company's industry group, and a thousand other factors can influence share prices, turning a stock you've just bought into a loser, at least on paper.

There's nothing worse than seeing your entire portfolio decline all at once. If you diversify your portfolio, you will be more likely to have at least one or two winners in your portfolio whenever the rest of your holdings fall in price.

You can look several ways at the diversification of a portfolio of stocks. The first way is to buy stocks from several different sectors or industries. That way, if the entire tech sector is in a slump, transportation stocks might be doing very well. If you own one technology stock and one airline, your portfolio could experience less "bouncing around" as stocks in one sector fall and rise in another.

The second way to consider the diversification of your portfolio is to hold shares of companies that are different sizes.

What's the Difference Between a Sector and an Industry?

A sector is a broad classification used to group companies that share common characteristics. For instance, Morningstar (and StockCentral) classify companies into the following sectors:

• Basic Materials
• Conglomerates
• Consumer Goods
• Financial
• Healthcare
• Industrial Goods
• Services
• Technology
• Utilities

Each of these sectors is made up of several different industry groups that further define the operations of companies. The Healthcare sector is made up of the following industries:

•    Biotechnology
•    Diagnostic Substances
•    Drug Delivery
•    Drug Manufacturers - Major
•    Drug Manufacturers - Other
•    Drug Related Products
•    Drugs - Generic
•    Health Care Plans
•    Home Health Care
•    Hospitals
•    Long-Term Care Facilities
•    Medical Appliances & Equipment
•    Medical Instruments & Supplies
•    Medical Laboratories & Research
•    Medical Practitioners
•    Specialized Health Services

Be aware, however, that different data providers use different classification systems when it comes to industries and sectors.

To find out which sector or industry a particular company belongs to, or to learn what companies make up a particular sector, you can use the Data Report and Stock Screener on StockCentral. Our FAQ includes a list of all sectors and industries, as well as the companies that each include. And it works the other way, too. If you search for a company report, you will find out what sector and industry that stock belongs to.

The second way you can look at the diversification of your holdings is by buying companies of differing sizes. Studies have shown that the stocks of small companies tend to increase in price at completely different times than large companies. When large company stocks are rising in price, small company stocks tend to stagnate, and vice versa.

Also, small company stocks are generally more volatile than large company stocks. You can expect a portfolio that's made up of nothing but small stocks to experience big swings in price. But a portfolio that includes large, small, and medium-sized companies can have less overall risk and still provide a good return.

Determining a Company's Size

While much of Wall Street measures a company's size by it's market capitalization, you can get a truer picture of a company's size by considering its revenues. Although there are no hard-and-fast rules for how to categorize companies after you know their market cap, here is what we use here on StockCentral:

• Micro    Less than $100 million
• Small    Between $100 and 500 million
• Mid-sized    Between $500 million and $5 billion
• Large    Between $5 billion and $50 billion
• Mega    Greater than $50 billion

The rule of thumb that clubs (and individuals) should follow is to focus on mid-sized companies for the bulk of your portfolio, striving to have 50% of your portfolio invested in these faster-growing but still well-established companies. Add in 25% of smaller and micro companies, and the remaining 25% in large and mega businesses, and your portfolio will have a good mix of some higher-growth companies; some slower-growth, blue chip companies; and the remainder right in between.

How Many Stocks?

For many clubs, the answer to the question of "how many stocks should we own" is usually 1 or 2 per person. A club of a dozen members can probably handle a portfolio of 12-18 stocks, which is right about the magic number to provides adequate diversification as long as the stocks in the portfolio are of high quality.

Own too many stocks and your returns are likely to regress to the norm -- in other words, your portfolio's returns (and risk) are likely to move closer and closer to that of the overall market. In that case, you might be better off giving up on investing directly in stocks and simply invest in an S&P 500 index fund or ETF!

The larger your portfolio is in value, it's probably worth increasing the number of different companies that you own. This is partly psychological -- if you own $2,000 of a stock that declines 10% in value, your loss on paper is just $200. But if you own  $200,000 of a stock and it declines 10%, that's a $20,000 paper loss, which could be painful. Even though we're talking about 10% in each case, the larger dollar amount can create a larger emotional hurdle to overcome when you need to make portfolio decisions.

Once your portfolio approaches $1 million in value, you might consider investing in as many as 30 different stocks, depending on your comfort level with what could happen if bad news hit one of your holdings.

Achieving Portfolio Nirvana

Your portfolio's diversification mix may be a moving target, and you may never find the "perfect" balance, but  knowing your portfolio's current diversification can help you make future investment decisions that help you move the portfolio towards your goals.

Some investors may have different thoughts about the most appropriate diversification plan for their stock holdings -- and that's fine, as long as you're comfortable with the increased risk or reduced return that might result.

Doug