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Why Diversification Is Important to Investors

Here’s a pop quiz: You own the following five stocks. These constitute 100 percent of your investable assets. Are you diversified?

Here’s a pop quiz: you own the following five stocks. These constitute 100 percent of your investable assets. Are you diversified?

  • Walmart (ticker: WMT)
  • McDonald’s Corp. (MCD)
  • Boeing Co. (BA)
  • Apple (AAPL)
  • DowDuPont (DWDP)

At first glance, it might seem so. You own a big retailer, a major restaurant chain, an airplane maker, a computer and phone maker and a chemical company. That’s pretty diverse, right?

Wrong.

These companies may hail from different industries and sectors, but they have one big thing in common: They are all large U.S. companies that are components of the 30-stock Dow Jones industrial average. Some newsletters and training courses (and even TV personalities) that espouse owning and trading single stocks encourage people to focus on just a handful of positions and watch them closely.

Warren Buttett’s Advise

Many cite a quote that’s widely attributed to Warren Buffett, although I could not find the original source of Buffett’s comment: “Keep all your eggs in one basket and watch the basket very carefully.” Keep in mind, Buffett began buying companies, not just stocks, years ago. Even if the quote is real, his “one basket” these days could arguably be his holding company, Berkshire Hathaway.

But for individual investors saving for a specific goal, such as retirement, the one basket rule makes zero sense. For example, the year-to-date return of the hypothetical five-stock portfolio above is 10.38 percent. The S&P 500 index has a return of 14.43 percent.

That under performance illustrates the potential downside of a concentrated position in just a few stocks. If one company you hold suddenly faces a serious problem, it could easily drag down your overall performance.

Boeing is largely responsible for the difference between the return of the S&P 500 and our hypothetical portfolio. The stock gapped 5.33 percent in seven times average trading volume on March 11, following the crash of an Ethiopian Airlines 737 Max.

More recently, news broke that safety features that potentially could have helped the pilots were considered optional, and that Boeing charges extra for those features. Ethiopian Airlines, and many other 737 Max operators, including some in the U.S., opted not to purchase these features. The stock dropped further on news that Indonesian Airlines canceled its order of the new jets.

Bad Investments?

Another, even worse example of a precipitous price decline is Biogen (BIIB), which, like Boeing, is an S&P 500 stock. The company develops treatments for neurological diseases. On March 21, the stock plummeted more than 29 percent on news that the company halted clinical two clinical trials for an Alzheimer’s therapy.

There are days when the market, as a whole, slumps (or worse) for various reasons: Institutional profit taking, bad economic news or no discernable reason at all. But as the recent experiences of Boeing and Biogen illustrate, company-specific declines can have an outsized effect on investors who fail to diversify properly.

Broad diversification is not nearly as exciting or glamorous as stock picking. That’s why you don’t see television channels dedicated to allocating mutual funds or exchange-traded funds. It would be far too somber and logical, missing any requisite entertainment value. Sadly, entertainment is not synonymous with a sound investment strategy, although the American public has been sold on the idea that investing should be exciting.

There’s no objection if a client wants to invest some “fun money” into a single stock or an industry-focused exchange-traded fund. Lately, several clients have wanted to put a few speculative dollars into cannabis stocks or an ETF tracking companies in that nascent industry. That’s fine, as long as this bit of speculation remains outside their predetermined stock-and-bond allocation designed to help them meet their retirement goals.

When meeting with clients, a quote from Paul Samuelson, the first American to win a Nobel Prize in economics, is often cited. He was quoted in Paul B. Farrell’s 2004 book, “The Lazy Person’s Guide to Investing: A Book for Procrastinators, the Financially Challenged, and Everyone Who Worries About Dealing with Their Money.” Samuelson said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

That’s sound advice for anyone who wants to enjoy growth of investments, while diversifying away company-specific risk.

 

About the Author

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Kate Stalter

CMO and Senior Financial Advisor

Kate is a Series 65-licensed advisor, has hosted the Daily Stock Analysis and Market Wrap videos on Investors.com, and taught Investor’s Business Daily live seminars. She contributes to Forbes, US News & World Report and TheStreet. Kate’s primary focus is helping clients who face decisions about portfolio allocation, Social Security strategies, insurance needs, estate planning, college funding and all manner of financial questions.