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 With stock ownership, it's certainly possible to have too much of a good thing. Diversity of stock holdings is important - just ask any former employee of Enron. When that company filed for bankruptcy, thousands of employees lost nearly all their savings.
In this article, we're going to explain why experts feel you should avoid putting more than 10% of your portfolio's assets into one company's stock. We'll also explain how to go about diversifying your portfolio, as well as providing an example to demonstrate the positive impact holding an assortment of stocks can have on your return on investment.
Diversifying is Important
When you spread your money across a variety of investments to reduce risk you're practicing diversification. And if you can choose the right groups of investments, then you can even limit your potential losses without compromising your potential gains.
Owning too Much of One Stock
A much-cited example of the pitfalls of owing too much of one stock is what happened at Enron in late 2001. Studies conducted after Enron filed for bankruptcy showed that 57.7% of the 401k plan funds at Enron were invested in company stock. When the price of Enron's stock fell by nearly 99% in 2001, employees were financially devastated.
The publicity around the Enron debacle highlighted the risks that some companies allowed, and even encouraged. This misfortune subsequently prompted a number of studies aimed at quantifying the extent to which employees hold stock in the companies for which they work.
A study conducted by the Investment Company Institute (ICI) and the Employee Benefits Research Institute (EBRI) conducted in 2001 found the following:
- Nearly 25% of employees over the age of 60 held 50% or more of their 401k funds in company stock.
- Sixteen percent of employees over the age of 60 held 80% or more of their 401k funds in company stock.
More recently, a study conducted by Financial Week and Pensions & Investments evaluated the 401k asset allocation strategy for 65 of the largest corporate defined-contribution plans. That study found:
- Over 81% of these companies had 10% or more of their 401k assets invested in company stock.
- Forty-two percent of these companies had 25% of more of their 401k assets invested in company stock.
- Several companies included in the study - such as General Electric, Duke Energy and Chevron - had more than half of their plan's assets in company stock.
To put these percentages in perspective, financial planners typically recommend that not more than 10 to 20% of an individual's assets be placed in one company's stock. This recommendation stems from the fact that owing too much of one stock increases the risk of that individual's portfolio.
Individual Stock Risk and Diversification
Employees typically invest in their companies because of a natural tendency to invest in something that is familiar. Adding to that tendency is our natural fear of the unknown. These two human factors result in the unusually large holdings of single stocks by individuals.
Financial planners understand that diversification can reduce the risk associated with investing in stocks. We can demonstrate the benefits of holding a diverse portfolio of securities with a simple example:
Reducing Risk - Example
In this example, our universe of stocks is limited to ten companies, and we have eleven investors. Ten of these investors have 100% of their assets invested in a single stock, while one investor invests 10% of their assets in a portfolio consisting of the ten companies.
In our example, one of the companies files for protection under Chapter 11 bankruptcy and the shares of that stock have no value. The remaining nine companies all provide to their investors a 10% return on investment. The results of this example include:
- Nine investors received a 10% return on their investment.
- One investor lost all their money.
- One investor received a 9% return on their investment.
By holding a diverse set of stocks, the investor realized a slightly lower return on investment, but they also eliminated individual stock risk. This strategy is the first layer of protection that holding a variety of stocks offers investors.
Diversified Stock Portfolios
Generally, an investor acquires two risks when they own stocks. The first risk is individual stock risk, and that risk can be reduced via diversification as demonstrated in the above example. The second risk is market risk. This second risk is influenced by macroeconomic conditions - such as a recession or depression - and / or investor faith in the stock market itself.
While it's relatively easy to reduce the risk associated with the performance of one company's stock, it's much more difficult to reduce market risk. In fact, there is even a measure that tells us how strong the relationship is between the market's overall movement and that of an individual stock. That measure is called the stock's beta.
Stock Beta Values
The beta value of a stock quantifies the likelihood that a stock's price will increase or decrease at the same rate as the stock market itself:
- A stock with a beta >1.0 can be expected to experience price swings that are greater than the market's movements.
- A stock with a beta = 1.0 can be expected to experience price swings similar to the market's movements.
- A stock with a beta between 1 and 0 can be expected to experience price swings that are less volatile than the market's movements.
- A stock with a beta < 0 (a negative beta) can be expected to experience price swings that run counter to the market's movements.
Please note that while it is mathematically possible for a stock to have a negative beta, the actual occurrence of this condition is highly unlikely.
Investment Sectors and Mutual Funds
One strategy that investors adopt to help reduce the risk of their stock holdings is to diversify not only by holding the shares of stock in a variety of companies, but also to diversify across industries or sectors. The most widely recognized market sectors include:
- Information - Hardware, Media Software, Telecommunications
- Service - Business Services, Consumer Services, Financial Services, Healthcare
- Manufacturing - Consumer Goods, Energy, Industrial Materials, Utilities
What the investor is trying to achieve by spreading their money across a variety of sectors is a variety in performance. That is, each sector can be expected to perform differently under a variety of market conditions thereby offering the investor the possibility of extraordinary gains in one sector even if another sector underperforms relative to the overall market.
So just how many different stocks does it take to have a diversified portfolio? Nearly all financial planners agree that an investor needs to hold 10 - 30 different stocks before they can claim they hold a truly diversified portfolio.
Because of the difficulty and cost associated with creating a portfolio of stocks, many investors turn to mutual funds to achieve instant diversification. Even with mutual funds, the investor still needs to be aware of the investment strategy of each fund. Many narrowly focused mutual funds invest in a specific sector of stocks. This type of mutual fund can sometimes defeat the efforts of an investor looking to diversify their portfolio.
About the Author - Diversifying Your Portfolio
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