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Stock Diversification is the Key to Success
It can be very tempting to put all your eggs in one basket, especially if you believe in one company a lot.
You may have heard about meme stocks and how they “shot to the moon” a few years ago.
You read the Reddit message boards and its full of advice on what stock to buy.
Some of this advice comes from the right place but it is misguided. Properly diversifying your portfolio limits your risk while still allowing your money to grow.
Find out how this works by reading on.
Enron: A Tale of Not Diversifying
You have likely heard of Enron. It was an energy company that went out of business in the early 2000s. Accounting scandals, insider trading, and unethical management led to the company’s downfall.
When the company went down so did many of its employees’ portfolios. The reason was due to many of those employees being overexposed to the company stock.
You see the company rewarded employees by giving them stock. Those same employees also bought more of it in their 401(k)s or through warrants they owned. They did this because the stock was a superstar for years. It greatly outpaced the return on the market and was a media darling.
When news broke of all the misdoings at Enron the company quickly went out of business. The employees, who were invested heavily in the stock, lost everything.
This is why I stress the importance of diversification with my clients.
What is Diversification
The chart above is a great example of diversification. All that means is spreading your wealth to many different investments
Instead of putting all of your money in one stock, you are putting it in hundred or even thousands. The idea is to closely follow what the market is doing – not trying to pick a needle in a haystack.
This is a tried-and-true approach to amassing large amounts of wealth over time. In fact if you want to read more about it and why its important I would urge you to read The Little Book of Common Sense Investing by John Bogle.
Depending on your risk tolerance, following this approach can help you to earn more of a return. Check out this video made which can help set your expectations for what you could earn, especially if you are new to investing.
Diversifying means buying an index. This could be down through mutual funds, ETFs, or index funds.
It also means buying funds that follow different sectors of the market. Large cap, small cap, international, and bonds are all examples. There are many more to diversify your portfolio further.
Will I Beat the Market?
Following this approach, you won’t beat the market.
Now I know what you are thinking. “Ryan if I can’t beat the market, I don’t want to do it.”
And while that is a fair point, I would also argue that it’s not well thought out.
I know that a properly diversified portfolio does two things. First it limits risk and second it is used to closely follow an index.
So, if your index is the S&P 500 you should earn a return in line with what that has historically earned. About 7% after you adjust for taxes and inflation.
Compare that to bank accounts, which historically have earned around 1%. That is why you diversify.
The other caveat here is that you can invest in different sectors. So it is still completely feasible that you out earn the S&P 500 following this approach by overweighting certain sectors.
For example, let’s say you have a properly diversified portfolio. This limits your risk. But let’s also say that you believe that small cap and mid cap stocks will outperform the S&P 500 for the next year or two.
You could shift more of your portfolio to these areas and outpace the 7% the S&P 500 earns by a few basis points while still maintaining a well-diversified portfolio.
A Note About Stock Based Compensation
Many people tend to have concentrated stock positions because their work bonuses are paid as company stock.
These bonuses also typically have some constraints around them. This is known as a vesting period – or a period they have to wait before liquidating their stock.
It is important for these investors to come up with a plan to unwind these securities strategically. Taking into consideration taxes and the rest of your portfolio is important.
I recommend that no more than 10% of your investments be allocated to one stock. You are overexposing yourself beyond that point.
Unfortunately for these investors it is outside of their control. Working with someone like myself, you can come up with a strategy to unwind these securities and limit your risk.
This might take the form of simple liquidations or more sophisticated strategies like utilizing options. But given your unique situation it is important to have that conversation.
Case Study: The Pandemic
During the early part of the pandemic, we saw all stocks down significantly. Well diversified portfolios fell just as much a single stock portfolios.
Then something crazy happened. The market swiftly rebounded. Then even more strangely the meme stock phenomenon began.
Stocks like Gamestop and AMC doubled day after day and made people millionaires over-night. It was a huge craze that saw violent swings in those stocks that ruined people as quickly as it made them.
As the Pandemic progressed and things returned to normal, we saw well diversified investors start to again outpace those single stock investors. Even as the market has been rocked by high inflation and interest rates they still have done better.
This is the exact environment we would expect them to outperform. Because diversification limits risk, when markets are bad is when it wins. Because sometimes it’s not about how much money you make but about how much money you don’t lose.
Putting it All Together
Diversification limits risk and helps you to grow your money in line with the market.
Overconcentration in one stock may make you more money in the short run but long term it does tend to underperform the diversified investor.
How do you diversify your portfolio?