It used to be against the law to paint a horse blue, at least in Chicago. Like all laws, this one no doubt had its place.

The same can be said for the "Law of Diversification." You'll find it in every investment book: "You will diversify your stock portfolio." Such diversification generally does lower your risk by minimizing the potential loss from any single stock.

The law might also apply to mergers and acquisitions if companies treated the businesses they acquire as investors treat stocks. But they don't; and even if they did, in most cases the risk would grow the more they moved into diverse businesses.

Why? Because companies diversify only marginally. It's unrealistic for most businesses to diversify broadly enough to offer the sought-for security.

Mutual funds trade hundreds of stocks in many unrelated industries, with very little of the total portfolio in any single stock. By contrast, when a company expands into a new area, its portfolio consists of two stocks, typically 90 percent in the core operation and 10 percent in the new business.

In fact, for companies the Law of Diversification works in reverse: The more you diversify the greater your risk and the lower your return. Researchers consistently find much higher failure rates and lower returns for unrelated acquisitions than for related acquisitions. The lowest failure rates and highest returns actually occur when companies acquire businesses in their own industry.

Why is diversification into unrelated businesses so risky? The simple answer is that you probably aren't very familiar with the industry you're venturing into. Thus, you'll overlook critical risk factors during due diligence. You're likely to pay too much. And, once you've signed on the dotted line, you'll have trouble monitoring the new acquisition's performance.

Paint It Red Instead? Despite these warnings, you may still be considering an unrelated acquisition - buying a company outside your current core business. If so, here are some guidelines you should follow:

Don't Horse Around. No shortcuts allowed here. Due diligence must be thorough and flawless. Examine all the risk factors; know what you're buying. Your trusty old due-diligence checklists will be of little use in assessing a different type of enterprise.

A Horse, A Horse, My Kingdom for a Horse. Make sure the existing management team is capable of running the business and will stay on after the acquisition. Remember: You don't know the business. The last thing you want is to have to run it.

Don't Bite the Hand That Feeds You. Create handsome incentives for the existing management team. Keep them committed to the company's success and align their rewards with your company's performance objectives.

Prepare for the Long Haul. If the management team will be staying on for only a few years, make sure there1s a solid succession plan and that the next layer of management is highly qualified to run the business.

Don't Kick a Dead Horse. If the business starts to decline, stepping in to run it could be fatal. In fact, this is where conglomerates most often blunder: Rather than selling the company, as an investor would an unprofitable stock, they try belatedly to turn it around.

Diversifying out of your expertise is chancy and often calamitous - but making the move with wisdom, caution, and exhaustive preparation could be a horse of a different color.