Risk is an inherent part of investing. After all, no one can control the losses or gains of a particular asset, sector, or the market as a whole. But, you can take steps to manage your risk by diversifying your portfolio and avoiding overconcentration. Here’s a look at what diversification is, why it matters, and how to do it.
What is diversification?
Diversification is a technique that reduces risk and volatility in your investment portfolio. The idea is to invest across various asset classes, industries, and categories in an effort to reduce losses if a particular investment does poorly.
Imagine you held just a single stock. If that stock price plunges, so does the value of your entire portfolio. However, if you held 100 different stocks, when one stock’s value decreases, other stocks in the portfolio may hold their value or even increase in value, mitigating the loss. Holding several different asset classes, such as stocks, bonds, and real estate, further distributes your risk.
Diversifying across asset classes
Different types of assets come with varying levels of risk. For example, stocks have high growth potential and are relatively volatile, while bonds tend to offer less growth but are generally less risky.
Additionally, different asset classes may not respond to market conditions in the same way. In other words, they may not be correlated. For instance, an event that sends stocks plunging may have little effect on the bond market and vice versa.
You can also strengthen your approach by diversifying within asset classes. You may want to buy stock in companies across sectors, such as technology, industrials, or consumer staples. You may also consider buying companies of different sizes and across geographies. For example, large-cap companies may offer more stable returns than their small-cap counterparts, but small-cap stocks may offer more growth potential. Additionally, when domestic stocks are doing poorly, foreign stocks may be doing better.
When diversifying within bonds, consider that high-yield bonds don’t correlate perfectly with investment-grade bonds. You might also want to consider buying across different regions as well.
The role of mutual funds, exchange-traded funds, and index funds
Mutual funds, exchange-traded funds (ETFs), and index funds are other options, especially if the thought of selecting a diverse mix of investments yourself sounds intimidating. Mutual funds allow you to pool your money with other investors in a collective fund that is invested in a pre-selected mix of assets. These can include stocks, bonds, commodities, and other securities.
Most mutual funds hold more than 100 securities, giving them a level of diversification that would be difficult to achieve for most individual investors.
Index funds and ETFs are similar to mutual funds in that they hold a diverse basket of investments; however, they are managed differently. Mutual funds are typically managed by a professional portfolio manager who actively selects securities to invest in with the goal of beating the market. This type of active management can make funds more expensive to hold. ETFs and index funds, on the other hand, are usually passively managed and designed to track the performance of a specific index, such as the S&P 500. They may provide a cheaper alternative to actively managed funds.
Diversification does not eliminate risks or prevent investment losses entirely, but it does offer some protection against potential downturns by ensuring your portfolio includes investments that continue to grow while others may be declining. The further your portfolio sinks during a downturn, the longer it takes to recover, and diversification helps ensure you won’t have as far to climb when markets begin to rise again.
Why to Avoid Overconcentration when Investing
A concentrated position in a single stock can happen to investors for many reasons. They may receive company stock as part of their employee compensation package or they may have bought shares of a single company, hoping to choose a big winner.
However, it’s unlikely that a single stock will outperform the market as a whole. By only selecting a single stock, you can introduce a lot of risk into your portfolio. If your selected stock tanks, it can drag your portfolio down with it. Here’s a look at why concentrated positions are so risky and what you can do to mitigate that risk.
Why Choosing Individual Stocks is so Hard
Investing in a single stock can be tempting. However, it’s very difficult to pick one that’s going to outperform the market as a whole — even for professionals. Why? Millions of investors buy and sell stocks every day, and they react almost instantly to any new information about a company. As a result, stock prices tend to reflect all available information.
To choose a single stock that beats the market, you must find one that most people, including institutional investors, have overlooked. Institutional investors have access to vast amounts of information that the average investor does not, so it is unlikely you will spot something they haven’t already considered.
Most stocks actually underperform the market average, so even if the stock you pick does well in a given year, it’s likely that the broader market will still do even better. Over the long term, most individual stocks decline in value.
How Much is Too Much of a Single Stock?
A single stock position can still be a small part of your portfolio. The 5 Percent Rule is a popular guideline that suggests that no more than 5 percent of the total value of your portfolio should rest in any one asset. Because it is so hard to choose stocks that will beat the market, it is perhaps best to think of this portion of your portfolio as entertainment, or a place where you can experiment. Avoid investing more money than you are prepared to lose.
How to Prevent Overconcentration
To limit the risk of overconcentration, focus on developing a diversified portfolio that includes different asset classes. Go further by diversifying across sectors, sizes, and geographical regions.
Broad market index funds — which seek to replicate a market index — can be a helpful tool for diversification, spreading risk exposure across hundreds of different companies.
If you’ve just acquired company stock, you may find yourself in a concentrated position. For this reason, it can make sense to sell company stock soon after acquiring it, reinvesting the money in a diversified mix of stocks, bonds, and other investments. Selling stocks can trigger capital gains taxes, so you may want to work with an advisor to make sure you sell assets and reinvest as tax-efficiently as possible.
Sometimes you can end up overconcentrated in a single stock without trying. For example, let’s say that 95 percent of your portfolio consists of index funds and bond funds, while the other 5 percent is in a single stock. If that single stock has a great year and doubles in value, it could now represent much more than 5 percent of your portfolio. Avoid overconcentration by rebalancing your portfolio, which could mean selling some of your single stock position and buying more mutual fund shares. Or, it could mean directing additional savings to the index funds and bonds funds.
It’s impossible to eliminate all risk from your portfolio, but by avoiding overconcentration in a single stock and diversifying your portfolio, you can potentially mitigate it over the long term.
Reach out to the Emerj360 team if you have questions. The ability for you to lean on our dedicated, local team of financial professionals for one-on-one consultation when you need to is what sets Emerj360 apart.
Sources:
https://www.forbes.com/advisor/investing/buy-stocks
https://www.sec.gov/reportspubs/investor-publications/investorpubsinwsmfhtm.html
