Do You Own Too Many Risky Stocks?

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:

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:

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.