Eggs in a basket

DIVERSIFICATION VS. CONCENTRATION

Last week my blog covered risk because we deal with risk in our lives every day. It described the different kinds of risk and mentioned that financial risk is a part of investing. We sometimes become complacent when the stock market goes up and up and up, but there is inevitably a downside, and we have seen that recently.

So how do I deal with a downturn in the market? I don’t like it and I may even say a few choice words! It is not pleasant to see my net worth decrease. However, I will not let myself panic for a couple of reasons. First, I have a healthy emergency fund and may even add a little to it (see my blog, Your First Financial Step). Second, I have been an investor for a very long time and downturns in the market are a normal part of an economic cycle. They are not pleasant, but they are normal. Despite that knowledge, it might be tempting to want to sell some, or part, of my holdings, but I won’t because I have gone through a risk tolerance assessment. I know that I am invested in a way that matches my risk tolerance. In other words, the downside to the value of my investments is limited and matches what I can tolerate.

One of my previous blogs, The Key to Investing – Know Yourself, mentioned ways to assess your personal tolerance for financial risk. Before you start investing, or if you have already started and have not done so previously, please take the time to go through a risk tolerance assessment. Every major brokerage website contains an assessment tool, or you can just Google “risk tolerance assessment (or questionnaire). You might want to take a couple of assessments just to compare results.

A Message for Couples

My former husband and I had very different feelings about financial risk but, during our marriage, we compromised. It is often the case that spouses/partners have different risk tolerance profiles. Does one of you tend to push the boundaries and the other hold back and take a more conservative approach? How does that affect how you invest? What should you do? Start by comparing the results of your risk assessments and then discuss the differences. Is the difference a pattern in your relationship? If so, then this is no surprise. Is there a reason one of you feels more comfortable with financial risk? Perhaps you need to make up for lost time to reach a goal. Or maybe one of you grew up in a household that had to stretch to “make ends meet”, and the other was used to spending.

If the difference between you and your partner is not major – one risk assessment suggests 60% in stock and the other 70%, for example – you may agree to start with the more aggressive allocation (greater percentage in stock). If the volatility is uncomfortable after a while, say a year, then reduce the amount of stock. In light of recent market moves, you might want to do the opposite and start out more conservative. If the difference in your risk assessments is major, 60% stock and 100% stock, you may decide to split your investments into multiple buckets and invest some more aggressively (greater percentage in stock) and some more conservatively (less invested in stock) to make you both comfortable. After your discussion, you may find a good compromise between the two risk profiles. There is no right answer. This may be a tough decision, but it is important to make your investments work for both of you.

Diversification

Once you discover your risk tolerance, what do you do with it? Provided you have your living expenses covered, loans under control, and have an adequate emergency fund, you can start to think about investing for the long term. But what do you choose? There are so many, many products! That is both good and bad.

Last week’s article mentioned a common investment word – diversification. I like this word and the concept a lot! Diversification is the reason that I can rest easy when the market takes a tumble. Diversification means that you choose a wide range of stocks or bonds, instead of just one or two or a handful, and that reduces risk. The Motley Fool suggests you own 20-30 different stocks to be diversified. Other sources suggest as many as 50! Wow! Selecting that many different stocks seems like it will take a lot of time and energy and knowledge, and then they must also be continually monitored. Yes, that is true!

When I was an advisor in a brokerage branch, I had a client who was employed by a large industrial company. Let’s call my client Stan and the company he worked for ABC. Stan was very proud of ABC and spent most of his working life in its employ. ABC offered employees the opportunity to buy company stock at a discount. That is a good deal and Stan took advantage of it. ABC’s retirement plan account also allowed him to purchase ABC stock and Stan did. He also opened a brokerage account through which he purchased even more ABC stock. ABC company did well for a long time and Stan was thrilled. Whenever Stan came to my office to review his account, I talked to him about diversification, but he was willing to make only minor changes. Stan knew ABC in and out and was confident in its future. The last time I saw Stan was just before ABC took a huge hit in the market because demand for their major product plummeted. I tried to get in touch with Stan, but he would not return my calls. I am sure that Stan survived because ABC company switched its product line and is doing quite well, but I know that Stan’s plans for retirement must have changed.

If Stan had kept some of his ABC stock but diversified the rest of his accounts, he would have suffered but not to the same extent. Picking a single, or even a couple of stock winners is very difficult to do consistently over time – even for the pros! The added diversity of owning many companies and types of companies reduces risk.

Concentration

Concentration is the opposite of diversification. As Stan discovered, too much of one stock can work against you and that is called concentration risk. A rule of thumb says that you should hold no more than 5% of any one stock – Amazon, for example – in your combined investment accounts. Although Stan had a few other investments, his concentration in ABC was close to 100%!

If you choose not to reduce your concentrated holding and understand the risk to your portfolio, be sure to not only monitor the company but also its industry or sector. Disney, for example, is part of the entertainment industry and communication services sector, so news that affects those broad categories may affect Disney as well, and economic news may affect all: the industry, the sector, and the company. If you are employed by or deeply attached to a company, ask someone who is not emotionally attached to monitor the stock. As Stan learned, emotional attachment can blind you.

Concentration risk pertains to stock in a portfolio. The 5% rule does not apply to money market accounts, CDs, and savings accounts used for short-term saving. It can apply to mutual funds and exchange-traded funds, however. You must look inside the fund. To assess the concentration risk of mutual funds or exchange-traded funds, compare the top holdings. Yahoo Finance, under the Holdings tab, lists not only the top ten holdings but also the sector weights of a mutual fund or ETF. Similar information may be found on websites of brokerage firms or the website of the fund or ETF itself. If you are willing to pay a membership fee, Morningstar has a mutual fund instant X-ray tool for a more comprehensive analysis of combined fund characteristics.

If you are already investing and apply the 5% rule, you may find that you own too much of one stock. Is it possible for you to reduce the amount over time without taking large capital gains? Capital gains are the difference between the purchase cost and the sale proceeds. If your stock has been held for a long time, it has likely appreciated in value and, if held in a taxable account (an account in which annual income is subject to tax), you will pay capital gains tax on the net gains – the profit from the sale. Long-term capital gains are taxed at a lower rate than the tax rate for personal income. However, to qualify for the long-term capital gains tax rate the stock, bond, or other investment must be held for over a year. Taxes are important because, like fees and expenses, they reduce your return. So always check the purchase trade datethe beginning of the holding period, before you sell to try to get past the one-year mark.

Mutual Funds and Exchange-Traded Funds

If you read my blogs regularly you know that I recommend, especially for beginners, investing using mutual funds and exchange-traded funds (ETFs). Even as a mature investor, I still use mutual funds and ETFs. Why do they make the most sense? Because both allow you to spread risk via diversification. Typically, mutual funds and exchange-traded funds contain the stock or bonds (and sometimes both) of hundreds and sometimes thousands of companies and that is diversification. On top of that, they are managed by an investment professional. If you choose to invest in the stock of a single company or the bond of one issuer, or even a few, they may perform better than a mutual fund or ETF but, if you must make an unexpected sale, the risk of loss is greater when you own only a handful of stocks.

It is important to understand mutual funds and exchange-traded funds, their pros and cons and their differences, so stay tuned. Mutual funds will be the feature of my next blog and ETFs after that.

Thanks for reading and please spread the word! Your comments and suggestions are welcome and can be sent to me via my website, bevbowers.com.

Stay calm,
~Bev Bowers, CFP®

 

Legal Notice: This document is intended to be informational only. Beverly Bowers does not render legal, accounting, or tax advice. Please consult the appropriate legal, accounting, or tax advisor if you require such advice. The opinions expressed in this report are subject to change without notice. The information in this report is from sources believed to be reliable but are not guaranteed to be accurate or complete. All publication rights reserved. Use of this material is subject to the Copyright restrictions described on BevBowers.com.
 Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark and the CERTIFIED FINANCIAL PLANNER™ certification mark in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.