Stop Concentrating: Spread Out Investments to Fight Volatility Risk

Worried about volatility? Take a look at your portfolio, because if you have big positions in just a few names, you could be at more risk.
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If you’re worried about volatility awakening from its winter hibernation, you may want to take a look at your portfolio. A few stocks in there probably staged nice rallies after the election, but those bigger positions you now hold could make you more vulnerable if the market turns around.

Many financial professionals advise their clients to avoid building up a heavy concentration of money in just a few stocks—and the associated roller coaster rides that sort of investing can bring. It’s better, some say, to spread your assets across not only various investments such as equities, fixed income, and cash, but also within those categories, especially when it comes to the volatile stock market.

Volatility Vulnerability

Consider Investor X. He’s in his 40s, invests for the long term, and has about a 50% stock, 40% fixed income, and 10% cash portfolio. From that perspective, there’s some diversification. Peering into the equity portion of his portfolio, we find he owns several different mutual funds that are diversified among sectors and exposed to both domestic and international markets.

But his individual stock holdings include one position that makes up 10% of his total portfolio; another that makes up 9%; two that each compose 8%; and another that composes 7%. That means more than 30% of the investor’s total portfolio is in just four stocks.

From that perspective, it seems the investor could face serious risk should one of those stocks tank the next day when its CEO gets arrested for accepting bribes or its $1 billion medication gets pulled from the market for a safety issue. Admittedly, those risks aren’t high possibilities. But negative scenarios—including less dramatic ones like an earnings warning—do occur from time to time, which can push even very large stocks down 10% or 20% in a single day. That could mean thousands of dollars in losses for Investor X in a matter of minutes.

Avoiding Over-Exposure

How did Investor X build large positions in those stocks? It could simply be that he hasn’t done a close enough regular checkup of the portfolio, which would have told him that gains in those stocks had taken them to a level where they composed too high a percentage of his total. In other words, he picked good stocks, but his winning ways could end up coming back to haunt him. And if you think a major company can’t suffer a big stock loss, think again. Even some of the largest, most established companies have seen their share of dramatic pullbacks over time or in a single day.

Another possibility is that Investor X got too emotional about some of the stocks he owned, and decided to make big bets. Some feel it’s OK to do that now and then with “fun” money you can speculate with rather than invest, but not with money earmarked for key objectives like retirement.

To Investor X’s credit, he decided to work with a financial professional, who told him that limiting individual stock positions to between 2% and 3% can often reduce overall portfolio volatility from unexpected price falls due to negative earnings, revenue, growth, or news.

A diversified individual stock allocation could also provide growth opportunities for a portfolio, potentially with less risk, due to stock diversification. While having less exposure to individual stocks might mean fewer “wow” days when a stock that composes 10% of his portfolio goes up in a big way, Investor X may find that his portfolio can appreciate about the same as a portfolio with concentrated positions over the long term, and while decreases in value may still occur, instead of one stock taking a big hit, declines may take place on a more widespread basis based on sector, company, and economic outlook.

What Sort of Spread to Target?

Don’t assume that just keeping individual stock positions to a low percentage of your portfolio is all you need to diversify and have less volatility exposure. Even owning 40 individual stocks won’t accomplish that if they’re all in the same sector or two.

“By spreading yourself out, you have to be careful,” said Sam Stovall, chief investment strategist at CFRA. “Don’t confuse quantity with correlation. If you own 20 stocks, that’s good distribution if they’re in 20 different industries.”

How much of a spread do you need to cover the odds, so to speak?

“Academically, the answer has been 20 stocks in 20 different industries,” Stovall said. “It depends. If you have 11 sectors and you have 22 stocks, with two in each sector, then you can say you’re pretty well diversified. But even an answer as simple as that could cause someone to take issue. It’s an art, not a science.”


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