Spread Your Bets

By Daniel Kadlec

Peter Lynch became a fabled money manager and best-selling author mainly on the back of a simple investing principle: Buy what you know. But how can the average investor square that strategy with the equally compelling mantra: Diversify for safety? It's one thing for a pro like Lynch to gain enough knowledge about enough stocks to own only those that he understands--and still be diversified. He's got the time and resources. Most individuals, though, are doomed to a far narrower scope. Their best edge may always reside in the company or industry where they work.

And there lies the rub. Odds are you're already overinvested in the stock of your employer. Credit the explosive growth of 401(k) retirement plans, in which a growing number of participants receive a matching contribution in their employer's stock. In such plans, participants on average hold 54.6% of their assets in their employer's stock and, amazingly, many are raising that allocation even further, the Investment Company Institute reported last Thursday. The proliferation of stock options further skews more and more Americans' holdings toward the stock of their employer. What's more, some of your best ideas for investing in what you know will naturally involve the industry in which you work, including your employer's suppliers and customers--and perhaps even its competitors.

But keep in mind that your most valuable asset--your career--also is linked to the health of your company and industry. While you should invest enough in your 401(k) to receive any match that your employer offers, it's generally a mistake to voluntarily buy more of your employer's stock--no matter how bright you consider its prospects. Rough times can hit a company or an entire industry without warning. A portfolio diversified among five or more industries, including some that are sensitive to the ups and downs of the economy (airlines, builders, equipment makers) and some that aren't (food, drugs), gives you a cushion. If achieving diversification means passing up what looks like a sure thing in your field, so be it.

Some companies own enough diverse businesses so as not to pose much risk no matter how much stock you own. GE, for example, is in at least six different industries at home and abroad, from finance to broadcasting (NBC) to medical equipment. And, with a little work, it is still possible to gain an edge on enough companies in other industries to properly diversify. Lynch says the average person can spot two or three opportunities a year just by keeping an eye open for a hot new product or a perpetually crowded new store. A few evenings' research into the firm's financials and competitors, and you're set.

In this way and others, investing should be fun. I recommend setting aside a small portion (no more than 10%) of your portfolio to play hunches. Call it your fun money. If you want to take a flyer on a stock in an industry to which you're already heavily exposed, take the cash from your hunch pool. Meanwhile, make sure that your other 401(k) and any additional retirement accounts are invested in diversified stock funds or, if you're a stock picker, spread among other industries. There's nothing wrong with having confidence in your employer. But even Bill Gates sells Microsoft shares regularly to diversify.

See time.com/personal for more on diversification. E-mail Dan at kadlec@time.com See him on CNNfn at 12:45 p.m. E.T. Tuesday.