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Do You Own Too Many Risky Stocks?

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The most important lesson that investors learned from last year's financial crisis is that investing some of your money outside the stock market may cost you during bull markets, but it can save you from nail-biting drops during bad times.

That lesson isn't news to anyone who follows an asset allocation strategy that includes a combination of stocks, bonds, and other types of investments. Historically, putting certain percentages of your money into different investments has let you earn top returns while keeping your risk under control. Yet before you conclude that a simple allocation strategy will work for your finances, you need to take a closer look at exactly what stocks you own and how they might affect the way your overall portfolio behaves.

Setting your percentages
As it's explained in the most recent issue of the Fool's Rule Your Retirement newsletter, which asset allocation strategy you choose depends in large part on how soon you expect to need the money you're saving. Foolish retirement expert Robert Brokamp and his team have put together three sets of recommendations, broken down by how far away from retirement you are. For instance, if you have 10 years or more before you expect to retire, an aggressively invested portfolio with 90% stocks and 10% bonds gives you the best chance for growth. Meanwhile, after you've retired, the recommended allocation becomes much more conservative, with more than half of your money going to secure fixed-income investments.

Behind these allocation recommendations, though, are certain assumptions. In particular, because Brokamp typically recommends a combination of index funds and actively managed mutual funds, the allocations reflect how those broad asset classes have performed over time.

Yet many investors -- especially those who own mostly individual stocks rather than funds -- have more concentrated portfolios that don't necessarily reflect the market as a whole. If your portfolio is concentrated in relatively few positions, then you may need to adjust your asset allocation to keep a handle on your risk.

Beware of beta
Specifically, most investors measure risk in terms of portfolio volatility. In coming up with an allocation recommendation, one might assume that your large-cap stocks have roughly the same volatility as the S&P 500, while your small-cap stocks might match up with a benchmark like the Russell 2000.

The problem, though, is that if you routinely specialize in stocks that behave differently from the overall market, you'll have a much different risk level even if you have the same allocation. High-beta stocks exhibit much greater volatility than low-beta stocks, so if you have mostly high-beta stocks in your portfolio, it would be riskier than a low-beta portfolio of the same size.

Here's an example. Say your large-cap stock allocation is made up of these five high-beta stocks:

Stock

Beta

3-Year Average Annual Return

Citigroup (NYSE: C  )

3.05

(54.3%)

Bank of America (NYSE: BAC  )

2.66

(27.2%)

Office Depot

3.52

(44.6%)

XL Capital (NYSE: XL  )

3.17

(32.7%)

Wyndham Worldwide

3.66

(16.8%)

Source: Yahoo! Finance.

This portfolio has offered a pretty rough ride. Not only have these stocks all suffered significant losses during the past three years, but they've also experienced wide swings -- all of them are multibagger winners since March.

On the other hand, consider this group of five low-beta large-cap stocks:

Stock

Beta

3-Year Average Annual Return

Altria Group (NYSE: MO  )

0.47

3.9%

Southern Company (NYSE: SO  )

0.34

2.3%

Amgen (Nasdaq: AMGN  )

0.40

(5.1%)

General Mills

0.29

7.3%

Campbell Soup (NYSE: CPB  )

0.30

(2.5%)

Source: Yahoo! Finance.

Notice the difference. These stocks have been much more sedate than their high-beta counterparts, both during last year's plunge as well as during the current rally.

Sizing up your portfolio
The point here isn't that low-beta stocks are better -- they have been recently, but only because the market has been down. Rather, an aggressive high-beta portfolio moves more vigorously than a conservative low-beta portfolio. Therefore, you need to realize that a given allocation in aggressive stocks will be riskier than the same allocation invested in more conservative stocks.

So if you own conservative stocks, you should adjust your stock allocation upward somewhat to compensate for its lower risk. But if you have aggressive stocks in your portfolio, you should reduce your allocation accordingly to keep your risk in check.

Having the right allocation gives you the best chance to match your portfolio with your desired level of risk. By adjusting your stock exposure depending on which stocks you own, you'll help avoid getting surprised the next time the market drops.

Higher taxes are another big risk facing your portfolio. Read about three ways you can beat higher taxes before they beat you.

Fool contributor Dan Caplinger has a fascination with Greek letters. He owns shares of Altria. Southern Company is a Motley Fool Income Investor pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy couldn't hurt a fly.


Read/Post Comments (5) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 17, 2009, at 3:22 PM, DividendInc wrote:

    This article would be accurate of it displayed the beta for all stocks at the beginning of the 3 year period.

    Without 2006 beta figures, this article is misrepresenting the facts.

  • Report this Comment On September 17, 2009, at 4:18 PM, TMFGalagan wrote:

    Hi DividendInc -

    I recognize that if a stock's beta changes dramatically over time, then it may prove to have been riskier than one would have thought. In many cases, though, stocks' betas persist across long periods of time. In other words, although some stocks change from conservative to aggressive, many remain either conservative or aggressive for extended periods.

    best,

    Dan Caplinger (TMF Galagan)

  • Report this Comment On September 17, 2009, at 5:40 PM, CoffeeExplosion wrote:

    Stock market are very sensitive and may react to any incident related to politics, economics, government policies, natural calamities, association or dissociation between two business houses and so on. Because of this volatility, it is difficult to predict the performance of any stock and eventually make a profit, unless one adopts certain key strategies. Formulating the right strategy for stock trading may help to do business in a profitable way even when the market goes through a tougher time.

    There are numerous tactics and strategies for success in the stock market. In fact, some of the big financial houses spend considerably in researching algorithm to predict the index movement in the stock market. However, one can apply some basic analytics and risk-minimizing tactics for a fairly good result while trading.

    ------------------------------

    Money is like muck, not good except it be spread.

    http://www.topinvestingtips.com

  • Report this Comment On September 17, 2009, at 6:08 PM, 11787HOT wrote:

    THIS MARKET DRIVES ME NUTS. EVERYTIME I HAVE A LIST OF STOCKS TO INVEST IN, THEY GO UP TO FAST. THEN I HAVE TO WAIT FOR THE RIGHT TIME TO JUMP IN.

    WHILE ANALYSTS ARE ALL GIVING DIFFERENT

    OPINIONS ON THE SAME STOCK.

    MASUGANA.. LOTS OF MONEY ON THE SIDELINES

  • Report this Comment On April 10, 2014, at 1:42 PM, VianneyC wrote:

    Without a doubt, timeshare cancellation is the best and easiest solution to get rid of an unwanted time share. Once the contract is properly cancelled, the strings attached to the resort will be gone forever. Nevertheless, it is important to do the cancellation through the right people. There are many timeshare cancel professionals that ask for an upfront fee, and then they disappear. This is a good article on how to terminate ownership of a time share:

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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8/21/2014 3:59 PM
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