The Levels of Risk for Stock Investments – Why Diversification Is Key to Prudent Investment Management
Author: Nick Prigitano
Anyone who has heard anything about the stock market knows it’s volatile. There will be swings up and down. But, although past performance does not guarantee future results, historically over the long term, it has rewarded investors who have stayed the course.
However, when referring to the stock market, most people mean a broad-based benchmark (like the S&P 500) that invests in lots of different companies. Long-term returns are not the same for someone holding individual stock or a group of stocks that differ from the given benchmark.
One of the most basic aspects of prudent investment management is diversification—holding a large variety of different companies to spread out the risk. But what does diversification mean exactly, and what are you giving up in order to be diversified? Worse yet, there can be situations where someone thinks they’re diversified when they’re actually not. Here’s what you should know about the different levels of risk when holding stock investments and what to watch out for to ensure you’re actually diversified.
Starting at the very bottom of the risk hierarchy is investing in an individual stock. This is inherently the most risky because, as the saying goes, you’re putting all your eggs in one basket.
There can certainly be enormous benefits to this strategy . . . if you get lucky. By concentrating your investments in only one stock, if it performs exceptionally well and you have a lot of money in it, you can become exorbitantly wealthy. Your investment won’t be bogged down by other underperforming stocks in a more diversified portfolio.
But nothing in life is free, and the extraordinary upside potential comes at a cost. At worst, the company could go bankrupt, and you lose it all. Or it may possibly putter along, not really moving up or down much but providing no meaningful returns over a long-term time horizon.
Holding an individual stock is more akin to buying a lottery ticket than an investment strategy. You could certainly hit it big, but it’s much more likely the upside potential does not outweigh the potentially devastating downside costs.
In the ’90s, there was the dot-com boom. Any company that was starting on the internet could do no wrong. But we all know how that ended. For every one Amazon, there were maybe a dozen more Pets.com. Those who put all their chips on Amazon early are certainly reaping the rewards. (But – and it’s a big one – Amazon traded for $86/share in 1999 and fell to $8.60 in 2001 – a loss of 90%. Would you have held on?) For many of the other bets on start-up companies, investors lost it all. For this reason, when constructing a prudent portfolio, it’s best to avoid investing only in individual stocks—or to only allocate a small percentage of your overall investments to individual companies as a “sandbox” account, knowing that these investments are more of a gamble than a tried-and-true investment portfolio.
The next level up from individual stock investing is investing in a sector. A sector can be fairly broad (such as technology companies) or can be refined more narrowly (like cloud storage companies). Sector investing is a little more diversified than buying individual stocks but still carries significant risk.
When investing in a sector, you reduce the risk of an adverse event affecting a single company (think Enron). But since you’re investing in a sector, certain events may impact all companies within that group. For instance, the increasing cost of semiconductors impacts the costs of many tech companies. Your overall allocation is still quite concentrated on specific risks to individual sectors.
Since you are diversifying a little bit, your upside potential won’t be as high as investing in one stock. However, your downside is reduced because if one single company drops it does not mean the same will occur with the other companies within that sector. But generally, investing in one sector is considered inadequately diversified when it comes to a complete investment portfolio.
US-Based Index or Passive Funds
When investors talk of adequate diversification, they are usually referring to index or passive funds. Investing in a broad-based index or passive investment fund will provide exposure to many different individual stocks that are composed of many different sectors of the economy. This spreads out the risk so that certain adverse events that impact individual companies, or only certain sectors, do not derail the entire investment. Of course, certain events such as a recession will impact stocks negatively overall. But diversification among many sectors can help mitigate that risk.
Just like moving from individual stocks to sectors, moving upward to diversified index funds will reduce your potential for an outsized return even further, but it will also drastically reduce your overall risk. While past performance does not guarantee future results, investing in broadly diversified stock investments over the long term is one of the best ways to produce returns that exceed inflation (and who isn’t thinking about inflation right now). Diversification has historically been one of the few places where investors can have their cake and eat it too. A properly diversified investment portfolio can increase your expected returns while reducing your overall risk, and who doesn’t want that?
When reviewing passive or index funds, though, it’s important to research what the fund owns. Just because a fund is following an “index” does not mean it is necessarily diversified. For instance, investing in a fund that tracks the S&P 500 is widely considered a diversified investment because it’s composed of 500 individual companies in every sector of the economy. However, the Dow Jones Industrial Average has only 30 stocks in it, and arguably isn’t really a good benchmark for a diversified investment or a gauge of the economy as a whole.
To expand diversification even further, it is often a good idea to invest in international companies as well. This will include both developed international markets (like much of Europe) and emerging markets (like much of Asia, Africa, or Latin America).
Just like with US investing, it’s best to use broadly diversified international and emerging market funds that are composed of numerous individual companies and sectors. Having a well-diversified global investment portfolio made up of broad passive or index funds is at the top of the diversification pyramid.
When Diversification Is Not Diversification
Having a goal to construct a well-diversified investment portfolio is a good thing. However, many investors don’t always know what real diversification is or are diversifying the wrong things. Here are a couple of items to watch out for when constructing your portfolio:
A common pitfall with investing, even when using funds instead of individual stocks, is investing in funds that are materially the same or overlap significantly. For instance, what is the difference between the SPY, IVV, and FXAIX funds? Not much. All three of those funds are S&P 500 index funds. They’re operated by different companies: Two are ETFs, and one is a mutual fund. Their expenses differ slightly, but they’re all essentially the same thing. Diversifying by buying different funds is not really diversifying if they hold the same underlying companies in the same amounts.
While the above is a somewhat extreme example, it’s certainly not uncommon to find someone investing in a large growth fund, a mega cap fund, and an S&P 500 fund. All of these funds may track different indices, but because of the types of stocks that make up those indices, there is likely significant overlap of the individual stocks that make up those funds. This can lead to a situation where someone thinks they are diversified but are really more concentrated than it may appear. It’s important to check the underlying holdings of your investments to ensure you don’t have significant overlap.
There’s a reason why we generally recommend passive or index funds for stocks over actively managed ones. Index and passive funds are usually less expensive than actively managed funds, and the research has shown that these funds typically outperform their actively managed counterparts over the long term.
Will active funds outperform passive ones during the year? Absolutely. Does short-term outperformance materially predict future outperformance? Not really. Many active funds that outperform the market one year tend to underperform the next. This is the conundrum with actively managed investments. Logic would assume that individuals and teams that have superior research and knowledge should be able to consistently beat the market, but that has not been the case. Some of it has to do with the higher fees charged for that additional research and work, which hinders returns. Even more of the reason has to do with how difficult, if not impossible, it is to consistently and accurately time the market. This is true for both individual investors and Wall Street pros alike.
We talked a bit about how diversification reduces overall risk in an investment portfolio while increasing expected returns. However, using active fund managers for your stock portfolio adds an additional risk . . . having to pick a fund manager. This additional risk historically has not been worth it over the long term.
The first issue with this is that in order for a fund manager to produce returns materially different from the market, they need to invest differently from the market. This may mean concentrating the underlying stocks more in either certain sectors or individual companies. Depending on the fund, this may reduce the overall diversification you’re getting.
Second, just as no one can predict the stock market in advance, no one can predict how a fund manager will perform in advance. There have certainly been legendary stock pickers, like Warren Buffett or Peter Lynch, who have shown that they can consistently beat the market over the long term. It’s important to note that these individuals are the exception rather than the rule. But it’s also important to realize that no one knew beforehand that these fund managers would outperform. It’s difficult enough to try and guess which individual stocks will “beat” the market. It’s another challenge entirely to evaluate which fund manager with which specific strategy will outperform. Both are a fool’s errand and should generally be avoided.
We find that active management is usually an additional unnecessary risk that is not needed in a prudent investment portfolio. Sticking with low-cost passive or index funds is simpler (doesn’t require you to evaluate a manager and their strategy) and generally, over the long term, outperforms active management anyway.
Diversification is a key concept when it comes to prudent investment management. But diversification is more than just investing in a bunch of stocks or funds. It’s ensuring that the funds you hold are broadly diversified by investing in lots of individual companies and sectors within the economy. It also means reviewing your individual funds to ensure that the stock holdings don’t overlap too much so that you’re actually diversified.
What’s remarkable about diversification is that, when done properly, it has been shown to reduce overall risk while increasing your expected returns. But diversification in some areas, like picking different active fund managers, is not real diversification, and, in many cases, can add an additional layer of risk to your investment portfolio.
If you need help managing your investment portfolio, please reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisor.