Individual Stocks and Diversification

In another article, I wrote about a client who originally had his 401(k) invested 100% in company stock.  The gist of that article was to highlight the importance of investing according to your risk tolerance, given that his original investment was very aggressive, while his risk tolerance was conservative.

But what if his risk tolerance had indeed been very aggressive, as well?  Would his original investment have been then suitable for him?

In a word, no.

No matter how aggressive an investor you are, investing in one company, or even a few companies, is not a wise move.

A Few is Fine, if They’re Quality, Right?

Let’s say you have your portfolio invested roughly equally in five stocks, all strong companies like Coca Cola, Home Depot, Apple, etc.  Return over the long-term has been good.   You think your portfolio is sound.

But what if something happens to shake the very foundations of one of those companies?  What if poison somehow makes its way into millions of bottles of Coke Zero?  Millions of people die from the poison.  Coca Cola is plunged into a legal nightmare.  Pepsi takes advantage of its foe’s troubles by advertising its production process security and quality control measures.  Stock price plummets amid reports of Coca Cola’s eminent ruination.

Where is the value of your Coca Cola investment now?  What if your kid’s college tuition is due and you need to sell Coca Cola stock a month after the first poisonous death?   You could be selling at a loss.  The tax benefit you gain from the capital loss would be pittance compared to the harm it does your portfolio.

Ok, this is surely an unlikely scenario, as Coca Cola’s own quality control and product testing measures are in place to prevent this from happening.  But it’s not impossible.  And you have 20% of your portfolio riding on Coca Cola’s bottling process.  Even the simple market price variation of the stock could be problematic if you need to sell at the wrong time.

Good Diversification Means More than Five

A properly diversified portfolio does not have large concentrations in any one company.  A good portfolio includes hundreds of companies, even thousands if you use funds and not individual stocks.  In such a portfolio, concentration in any one company could be as low as 1%.  If that one company goes under, the impact on your overall portfolio would be miniscule.

So More than Five is All I Need?

Not exactly.  Good diversification also means choosing the right combination.  You don’t want to own the S&P 500, and only the S&P 500.  You don’t want all American companies.  You need a mix of different types of asset classes.

Correlation in the finance industry is a quantitative measure of how closely two investments react compared to each other.  A correlation of 1 indicates that the two investments are perfectly correlated – meaning they will react the same way to changing market conditions.  The closer the correlation is to 1, the more similarly they will react.

A correlation of -1 indicates that two investments will react the opposite of each other.  The closer to -1, the higher degree of opposite directions.  A correlation closer to 0 indicates that the two investments move in ways that are not related to each other.

In relation to your portfolio, you want to make sure you have investments that are not closely correlated.  This involves choosing investments whose correlation approaches 0.  Another technique sometimes used is hedging.  A hedge is an investment used to offset potential losses that may occur by another investment.  This is most often accomplished by using investments involving negative correlation.

Using the S&P 500 example (the S&P 500 includes the 500 largest US companies), a good companion investment would be bonds. Or money markets.  Or foreign stocks.  A hedge against a falling dollar could be investing in foreign bonds in their local currency.

Of course, diversification does not protect you from systemic risk.  As seen in 2008-2009, if the whole market goes down, your portfolio is going to go down with it.  Highly volatile markets tend to erase the benefits of correlation.  You can’t control this kind of risk, like you can investment risk, but that is no reason to forgo diversification.

Enough is Enough

So it’s not enough to choose just a few stocks.  It’s not enough to choose a large amount of the same type of investment.  A desirable portfolio will focus on global long-term healthy asset classes. Within each asset class, a focus on historical volatility, correlation to the S&P 500 and potential future return will net the best results. Such a portfolio is much more efficient, in terms of risk and reward, than just a few stocks of all one type.