"Don't put all of your eggs in one basket" is an investing axiom repeated ad nauseam for good reason. Studies show that above all else -- including market timing and even the actual securities in which we invest -- our investment returns overwhelmingly hinge on the diversification of our assets. But we often fall victim to the tendency to go for broke and greedily swing for the fences.
Common transgressions
Consider the following four situations that put us at risk of overconcentrating our portfolios in any single position.
1. Owning too much company stock of our employer
The benefits of owning our company stock often include the ability to purchase the stock at a discount and to dollar-cost average into the position. Employees also buy stock as a badge of pride in their employer. These can all be good reasons -- but too much of a good thing is still too much.
As a financial advisor, I reviewed many individuals' 401(k) statements with overweighted positions of company stock. It was not uncommon for employees of a nearby Hershey (NYSE: HSY) plant to have Hershey stock represent nearly half of their 401(k) balance. While Hershey stock outperformed the S&P 500 over the past five years as demand for its products held up even in the wake of highly volatile cocoa prices, this could have easily gone the other way.
Enron serves as a classic example of how this can go horribly wrong. In the company's demise, employees not only lost their jobs, but many lost their livelihood because their retirement savings were invested mostly in Enron stock.
2. Investing in an industry with which we are very familiar
It's tempting to fall into this trap. While industry knowledge can give us a leg up, this familiarity fosters a common investing pitfall. For example, doctors prescribe medicines and use medical technologies daily. It's enticing for an orthopedic surgeon to load up on shares of MAKO Surgical (Nasdaq: MAKO), a medical device company that enables surgeons to perform knee and hip replacements, if the good doctor strongly believes in its products. But there's a big risk if you overconcentrate in a single sector or position, no matter how good its prospects may be. If either the sector suffers or the technology falters, then the portfolio deteriorates.
3. Not selling our stock winners to avoid Uncle Sam
Avoiding the sale of a stock to forestall paying taxes on gains is common. But this tactic threatens our potential overall portfolio returns. Had you bought Google stock seven years ago, you'd have more than doubled your money. By not harvesting your gain and paying Uncle Sam his share, you'd increase your position in Google relative to your other stock holdings. But with time, your unsold winners overconcentrate your portfolio and increase your risk.
4. Doubling down on a hot stock
Often the biggest threat to a well-diversified portfolio is the workplace-water-cooler-stock-jockey letting you in on the latest hot stock tip. After a five-minute conversation he has you so convinced that you are logging into your online account, selling your diversified blue chip stock portfolio, and doubling down on the hot stock of the week.
Don't let greed overwhelm rational thinking. IPOs are a great example of this. While you may be tempted to reposition your entire IRA balance into Facebook (Nasdaq: FB) stock at its now apparent bargain price, this isn't a smart strategy. Not only does this place your portfolio in grave danger from a diversification standpoint, it does so with a company characterized by risky revenue sources and unproven monetization. No single stock is such a sure thing that it warrants putting all your money into it.
Eggs in that proverbial basket
If the idea of building a diversified portfolio from scratch seems daunting, mutual funds and exchange-traded funds are simple solutions. Look for funds that offer broad diversification across geographic regions, market capitalizations, and sectors so that if one country or sector is flailing, your entire portfolio won't fail. An example is SPDR S&P 500 (NYSE: SPY), a broadly diversified ETF which mirrors the S&P 500 index.
To avoid letting well-intentioned risk management spiral into speculation:
- Limit any single stock position to no more than 5% of your overall net worth.
- Use caution when loading up on stock in an industry with which you are intimately familiar.
- As difficult as it is, sell your winners when it's necessary for the overall health of your portfolio.
- Don't let speculation become the rule rather than the exception.
By following these guidelines, you'll minimize risk and sleep well at night.
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