Putting Your Investment Eggs in Multiple Baskets
How Diversifying Your Portfolio Can Increase Your Returns
We've all heard the reasons to diversify your portfolio – by spreading your investments across different sectors and asset classes, you limit how much you could lose should any particular stock, sector or class suffer a downturn. Yet despite your best efforts, your diversified portfolio can still develop concentrations of a particular investment over time, be it from inheriting stock, receiving executive compensation through stock options or simply because one stock in your portfolio appreciated in value more quickly than the others.
No matter how a concentration position develops, if your portfolio is overweighted in any one position, you’re exposed to undue risk.
Know Your Terms
A concentrated position is when an investor owns shares of a security that represent 10% or more of his or her portfolio’s overall value.
Risks and Rewards
To understand the risks associated with a concentrated position, we compared the individual performance of 309 companies consistently listed on the S&P 500 between 2006 and 2016 against a hypothetical diversified portfolio (60% equity / 40% fixed income). We found:
- More than 1/3 of the individual stocks on the S&P 500 underperformed our portfolio
- Of those, 55 failed to keep pace with inflation, and 37 had a negative return over the course of the 10 years
- Volatility for each of the 309 stocks was more than 3× greater compared to our diversified portfolio
Lower Volatility = Greater Returns
The increase in volatility is an especially important finding for investors looking to maximize their returns. As our study and many others have found, increased volatility can reduce the power of compounded growth – and as a result your future wealth. Take the following comparison of two hypothetical stocks:
- Investment A averages a 10% return over two years but experiences greater volatility: a +50% return in year 1, but -20% in year 2
- Investment B also averages a 10% return but with less volatility: +15% in year 1 and +5% in year 2
With an equal average return and a relatively short time period, you might expect the wealth generated to be roughly the same. Let’s see how it turns out with a $100,000 investment:
|Original Investment||Year 1 Returns||Year 1 Balance||Year 2 Returns||Year 2 Balance||Compounded Growth Rate|
Even though both investments average a 10% return, the compounded growth rate and total wealth gained are drastically different. The more an investment’s return negatively fluctuates year by year, the greater the drag on its future wealth.
Strategies for Managing Risk
Even when we understand the benefits to a diversified portfolio, it can be hard to decrease our holdings in our favorite stocks. Here are some of the common reasons investors give for holding on to concentrated positions, as well as advice on how they could benefit from a change in perspective:
- “If I were to sell, I’d have to pay more in capital gains.” While this might be the case, it’s worth remembering that capital gains tax rates right now are near historic lows. Moreover, the longer your time horizon, the more likely you’ll be able to recoup any tax hit.
- “I’m legally restricted from selling.” In some cases, corporate executives may be prevented from selling under Rule 10b5-1. If that applies to you, consider diversifying around your restricted stock in a way that counterbalances the additional risk.
- “This stock has grown every year I’ve owned it.” While past performance can be a helpful guide, investing is about looking toward the future. Reducing a concentrated position, no matter its past performance, can help safeguard against risk in an unknowable future.
- “What if I sell now but the stock continues to rise?” While that’s a possibility for any investment, the wealth generated by your total portfolio is more important that any one stock. Focus instead on your whole portfolio’s long-term potential and how you might mitigate risk.
- “This stock was at an all-time high not long ago – selling now feels like taking a loss.” The stock may reach that high water mark again – or it could further decrease in value while you wait. It’s better to put your money to work in a more prudent, diversified fashion.
- “I don’t want to sell stock I inherited from my grandparents” or “I don’t want to sell stock in the company I worked for.” Be wary of mixing sentiment with investing. Diversifying might be a wiser way to maintain that legacy and your objectivity.
- “My stock options don’t really count as stock.” Stock options are equity holdings and can constitute a concentrated position. There are unique tax consequences from selling incentive or nonqualified stock options, though, so be sure to contact your tax or financial advisor before taking action.
It’s worth remembering that if you’re looking to diversify your portfolio, you may have strategies available to you beyond selling stock, such as through exchange funds, charitable remainder trusts or certain hedging strategies.
Your Baird Financial Advisor can guide you through your alternatives for diversifying and help you stay focused on your broader financial goals.