We get questions from time to time about buying individual stocks—or, more frequently, whether to sell a long-held, sentimental, or employer-issued position. Here are a few reasons why we almost always will suggest diversification into funds rather than concentrated positions in single names.
Fortunes have been made in legitimate companies like Apple and Amazon, but many have also been lost in disasters like Enron and Worldcom. Significant fraud, regulatory threats, or other pitfalls are usually obvious only in retrospect, and sometimes companies are just unlucky.
Financial media stirs up tremendous fear of missing out by focusing on big windfalls. The early Reddit investor who made tens of millions of dollars on GameStop gets tons of press, but there’s not much focus on the people who have broken even or lost lots of money on absurd stocks. Anyone can show you the stocks that have gone up 10,000% or more over the last 10 years, but nobody can give you a list of the ones that will do it in the next decade.
Employees with large positions in their company’s stock need diversification the most. When salary, bonuses, benefits, and maybe even a pension come from the same place, a portfolio loaded up with the company’s stock will make an unexpected stumble at the company worse, no matter how unlikely a stumble might seem. Being laid off is bad, but it’s much worse if you’re heavily invested in the company’s stock, and it starts to evaporate when you need it the most.
Despite obvious incentives to diversify, employees often feel conflicted about reducing exposure when their stock is free to trade. We often tell clients that there’s no stigma in paring down a position in your employer’s stock, no matter how upbeat the company’s prospects might seem or how strongly you believe in that future.
Companies go bankrupt all the time, but a globally diversified portfolio is unlikely to go anywhere close to zero outside an end-of-the-world scenario. This might sound surprising, but the goal of portfolio construction is not to aim for the fences and try to generate the highest possible return over every conceivable period. Most people wouldn’t regret paying their homeowner’s premiums if they go a decade without making a claim. In the same way, investors shouldn’t regret diversifying even if the stock they would have held instead happens to outperform the diversified portfolio over even a relatively long period of time.
Twenty-year-olds can bet everything on a risky stock because they can probably replenish “everything” in a few short months if things don’t work out. Someone moving toward retirement with a multi-million-dollar portfolio probably can’t replenish that nest egg in their lifetime, so every precaution possible — including broad diversification — is indicated as age and assets increase.
For these reasons, we almost always suggest moving away from single stock holdings to the extent possible. Academic finance suggests that diversifying away from “idiosyncratic” or “unsystematic” risk in a single stock is a free lunch — it’s not likely to reduce your long-term return but can greatly reduce your risk.
Those who chase hot stocks or put everything in their own company’s shares are the ones who should have fear of missing out: they are indeed missing out on the long-term benefits of a well-diversified, evidence-based portfolio.
