What a Well-Balanced Portfolio Should Look Like
Investors who are just starting out in the stock market either take one of two paths.
If they’re risk-averse, they may start investing with a mutual fund or ETF, which owns many stocks and makes management decisions on their behalf. The most common of these funds are index funds, which follows a specific stock market index on Wall Street, such as the Dow Jones Industrial Average, the S&P 500 Index, or the Nasdaq.
For individual investors who want to play the markets more aggressively, however, they may start investing in individual stocks. By buying individual stocks, an investor can focus on great companies rather than buy a fund, which has restrictions on what it can own and how much of its portfolio risk can be in any one position.
These investors, called active investors, can buy anything from penny stocks that funds can’t buy to some of the biggest market names like Apple (AAPL) or Microsoft (MSFT). Some may even want to use leverage to take advantage of low interest rates.
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As investors in individual stocks add positions, the more likely their returns will start to mimic the purchase of an index fund instead.
Why Diversification is Important
Reason #1: Avoid Large Losses
The saying “Don’t put your eggs in one basket” describes portfolio diversification to a T. If you put all your money into a single trade, and that trade doesn’t go well, you’ll lose your shirt.
That’s a problem. The first role of diversification is a defensive one. By owning many stocks, you’re ensuring that you avoid losses that could wipe out your entire portfolio. And you’re set to earn at least some kind of positive return over time. Owning a single stock subjects you to extreme portfolio volatility.
A passive index fund that contains all 500 stocks in the S&P 500 will have a company or two go bankrupt every year. Yet the fund has so many other positions, some of which are doing well, that investors can make great inflation-adjusted returns over time.
But an investor doesn’t need to buy all 500 stocks to get diversification. It really only takes as few as 10-20 positions to become diversified. And there are a number of funds that hold far fewer stocks than an index fund, which tends to hold a little bit of everything.
Reason #2: Increase Exposure to Large Potential Gains
Going back the idea of buying one stock versus many stocks, let’s say you find a stock that looks likely to shoot up tenfold or more in the next year. What it that doesn’t happen? What if shares rise a bit, fall a bit, but ultimately go nowhere? In that case, you missed out on potential gains elsewhere.
If you had a portfolio with five stocks instead, if one of them shot up massively as expected, three went nowhere, and one ended up being a total loss, you’d be far better off. That’s the power of diversification.
If you split your capital amid a number of opportunities, you increase the chances of a big payoff. The tradeoff, of course, is that some names will underperform, no matter how well they would have done otherwise.
Reason #3: Focusing on Dividends
Finally, investors focused on creating a dividend portfolio may want to gravitate to individual stocks over a fund or ETF. Funds typically pay low dividend yields, even the funds today that focus on dividend-paying stocks.
Ideally, a basket of dividend stocks will be bought combining a current high yield play along with some names that have a history of dividend growth, to ensure growing income over time. The beauty of dividend stocks is that you receive regular cash flow, which can be reinvested, and dividend stocks tend to have lower volatility.
That’s the kind of investing strategy that’s a bit harder to do with fund investing, which tends to focus more on capital appreciation than current income, although some strides have been made in recent years.
How Many Stocks is Too Many?
If you’re an active trader, you want to only have enough positions that you can keep track of at a given time. That’s usually in the 10-20 range. If you have a mix of some trades and some long-term holdings, that may even creep up a bit more to 30 or so total. But anything more than that may be too many stocks.
Studies have shown that, once you’ve got 20 different stocks in your portfolio, you’re likely to start mimicking the stock market’s average, as you’ve now got a sufficiently diversified stock portfolio. At that point, you’d only be diluting your potential returns on your best trades, as less capital is invested in them.
That’s assuming that those positions are in a variety of industries, and make up a variety of company sizes from penny stocks to tech stocks. If you’re invested in 20 different gold mining companies, you’re diversified within that sector, but far from diversified from the stock market as a whole, and subject to extreme volatility. It’s important to own many stocks across a variety of industry and sizes for true diversification.
How Investors Can Balance Active and Passive Investing
The wonderful thing about investing is that an investor doesn’t have to commit to a specific style. If you want to trade a handful of names as an active investor, while also combining a long-term investment plan, you’ll do just fine.
For example, a wage employee may have a 401(k) program. Under that program, employees can access the stock market for their retirement plan. Generally, these programs limit the investments to a number of mutual funds or ETFs, which own and manage many stocks on the fundholder’s behalf. That means investors in this program have to take a longer and more passive approach to the stock market.
An employee who sets aside some money in a 401(k) but also has a cash account for trading in more volatile stocks, or for making options trades, can take on an active role while still having a passive bent to their portfolio.
That’s just one way that an investor can balance passive and active investing. Simply putting some money into a mutual fund that tracks the market will have the same result of a passive 401(k) program.
How Many Funds Should I Own?
If you can invest in a number of stocks, why not a number of diversified funds? After all, there are thousands of funds and ETFs today. While there’s some overlap, many of these funds provide international diversification, a focus on different asset classes such as real estate or fixed income, and can invest based on market capitalization with a much wider view than a stock market index fund.
As with owning individual stocks, having a number of different funds should increase diversification. But spreading your capital too thin with too many funds will, in time, likewise lead to too much diversification. As funds and ETFs tend to have transaction costs and fees, it’s better to keep the fund side simple with no more than 5-6 different ETFs.
In the right areas and sectors, a passive investor can still get access to great growth stocks and value stocks alike, as well as companies large and small, and some other asset classes in there as well.
What if I Own Company Stock?
Many workers today either receive stock options as part of their compensation, or work at privately-held companies that also issue company shares under an employer stock ownership plan. The rule of diversification is more critical here than elsewhere.
Why? Consider the case of Enron. The company’s 401(k) program offered a sizeable block company stock for those investing in it, and the company issued stock options to employees at a large scale. But when the company declared bankruptcy, employees lost not only their jobs, but their retirement savings as well!
To avoid that kind of situation, it’s important to balance any company stock you do receive with investments elsewhere. And if you receive a particularly large amount of company stock, making reasonable, regular sales of shares each year will allow you to move that capital elsewhere where it can avoid a bankruptcy scenario.
By all means, you can own company stock, whether as an employee or owner. However, ensure you have enough wealth elsewhere that you won’t face personal financial ruin if you lose both your job and a large investment at the same time.
How Do the Pros Manage Their Money?
Professional money managers use all of the approaches outlined above. There’s really no one set way when it comes to stock investing, and anyone can be a successful investor no matter what path they take.
As a case in point, consider two of the greatest investors of all time:
Warren Buffett is famous for running a concentrated portfolio at times, even going so far as to say, “Keep all your eggs in one basket, then watch that basket.” While he has dozens of publicly-traded stocks in the investment accounts of his holding company Berkshire Hathaway (BRK-A), currently nearly 40 percent of those funds are in a single name, Apple.
At the other end of the spectrum, we have Peter Lynch, who ran the Magellan Fund for 13 years. In that time, he grew the fund from $18 million to $14 billion. While there, Lynch ended up holding many stocks– over 1,000 stocks in the fund in total! Although, when looking at his total returns, only a handful of those many stocks were responsible for the bulk of the fund’s profits. Still, it’s a lesson that diversification pays off.
The point is, when investing, there are plenty of paths of asset allocation that result in success for your portfolio.
Determining your systematic risk tolerance, and working with an accountant and financial planner to find the most tax-efficient way of investing based on your personal needs can lead you to a desirable outcome. That’s true whether you want to play the markets like the roulette wheel, or let a large fund continue to grow your wealth over time.