Cramer: Risk is a necessity, with these rules

Just as people must evolve with a changing world, so must a portfolio. That means that the traditional method of diversification based on selecting stocks from each sector is not going to cut it anymore. A new world with snazzy algorithm trading machines requires new rules to play the market.

So Jim Cramer focused on how to put together a diversified portfolio using a new strategy: stocks that will shield investors in any market while producing maximum benefit.

First on his list was speculation stocks. Cramer always talks about specs, but what exactly does he mean?

These stocks present higher risk, but also offer higher reward. Something to keep you interested!

When compared with the standard fare in Cramer's other strategy — think dividend yields and growth stocks — a high-risk stock hardly seems to make sense. Speculation always seems to be that dirty little word investors are told to avoid.

"Not only is it okay for you to own those tempting, risky, broken-seeming stocks that trade in the single digits, it's a necessity, as long as you follow my rules and speculate wisely," the "Mad Money" host said.

Investors need something with a little pizzazz to avoid boredom, Cramer said. High-risk, high-reward speculative stocks have a reputation of mystery, but if investors own them with the right rules and discipline, Cramer thinks they could also have huge upside potential for a portfolio, as well.

In the 1980s, solid stocks like Home Depot (HD) and Comcast (CMCSA) were even considered speculative. In fact, some of the biggest wins in Cramer's career came from speculation.

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So now on to the million-dollar question: How do you pick the right speculation stocks?

Cramer said the overall goal for spec is to invest in tiny, largely unknown companies in sectors that could catch a turnaround. That way, as Wall Street warms to the company, you will benefit from the gains.

Investors can identify a spec by looking for companies that trade in the single digits. Money managers at financial institutions will not touch the single-digit stocks because they think they are too risky. Investors benefit from classic mispricing created by pessimistic money managers, Cramer said.

So, once the fundamentals of a company turn, Cramer thinks it creates an opportunity to buy stocks at a great price that the big boys will not touch.

Speculation plays tend to have a short lifespan, he added. So, the trick is to lock in profits as soon as you have them and avoid getting burned. Cramer also advised investors to cut their losses before they become too large.

The next time the word speculation enters into an investment conversation, don't cringe. Instead smile, knowing that with a little discipline this could be a great opportunity for a $3 stock to turn into a triple.

Disclosure: Comcast is the owner of NBCUniversal, the parent company of CNBC and CNBC.com.

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