I thought I would never have to write another post on stock diversification. I honestly believed that there probably wasn’t anyone out there who still had everything invested in just one stock. I thought we talked about diversification just to talk about it, not because there was anyone who didn’t get it. Not diversifying was a joke we laughed about at parties and while golfing.
I was horribly wrong.
I have a co-worker, we’ll call him Steve, who is about 27 years old and extremely conservative when it comes to all things money. He spends little and saves quite a bit of his paycheck. Steve is single and has a decent paying job. Recently, I found out that his entire investment portfolio, outside of this 401k, is invested in one stock. One stock! Better yet, that stock is Nvidia – a tech firm. That’s a good idea because tech stocks never lose all or most of their value quickly (please read with lots of sarcasm).
Let’s take a look at what Nvidia has done year-to-date compared to the NASDAQ index.
As you can see, Nvidia YTD is only down by 2.99% while the NASDAQ index has fallen 1.42%. But look at the ride Nvidia has taken. In February, it had gains of 66% but come August, the stock had lost 23%. In fact, until two weeks ago, the stock was still -18% but has had a strong rally to cover most of those losses.
Let me make my point very clear. Investing in one, and only one stock, is very risky. Steve is exposed to not only market risk (the risk that the entire market has a downturn) but he has the extra exposure to the risk associated with just the one company. So for example, when Nvidia was down 18% two weeks ago, the market was only down 8%. So his investment took a double hit.
Does the Beta score help evaluate a stock’s risk?
Investors like to know just how volatile, or how easily affected, a stock is as compared to the overall market. That level of volatility is measured with a Beta score, which you can easily find on Google Finance. Nvidia has a Beta score of 1.60. What that means is that for every 1% that the market moves, Nvidia moves on average 1.6%. So if the market loses 1%, then Nvidia loses 1.6% and if the market gains 1%, then Nvidia usually gains 1.6%. But again, the Beta score only tracks the market volatility.
Here’s an example of a good stock turned bad
Netflix started this year by trading around $175. The price steadily rose to almost $300. Netflix’s Beta score is 0.73. Meaning, it doesn’t fluctuate as much as the market. It’s supposed to be a stock that’s less prone to market risks. But then the whole pricing fiasco happened. And then the whole Qwikster snafu happened. Netflix is now trading around $117. That’s a 33% loss year-to-date and a 50% loss over the last two months. So even though Netflix may not be prone to swinging wildly with market fluctuations, it is still susceptible to its own risks, volatility and in this case, stupidity.
Netflix appeared to be a good strong company. What if I had put all of my investments in during April, May or June while the stock was soaring? Well, I would have lost a lot of money. You might argue that in the long term I will recoup my investment. That’s not necessarily true. Many analysts, including Jim Cramer, are unsure whether or not Netflix can recover. Also, Netflix’s blow-up has given competitors an opportunity to come in and steal customers. So my money could be lost forever.
I am not arguing against taking risks
I am risk taker. I am an aggressive investor. However, investing in just one stock is downright stupid. It’s easy to look at it and tell yourself that you are invested for the long term so these market fluctuations are okay. Market fluctuations are okay in the long term, but companies going bankrupt or significantly underperforming are not okay. By investing in multiple stocks you hedge, or protect, yourself against the risks that come with any one company.
Just because you had one good stock doesn’t mean you know anything about investing
One of my favorite adages is, “Anyone can be a good captain on calm seas.” It’s easy to make money when everyone is making money. So if you picked one stock that did really well while the entire market was doing really well doesn’t mean you have any ability to time the market or out-smart 1000s of full time investors who have decades of experience, super computers and PhDs. Don’t let arrogance cost you your retirement. It’s almost juvenile to think you “know how” to invest after one lucky stock.
Steve is falling into this trap. He made money while everyone was making money and now thinks he can, in a few minutes a week, make smart, individual stock choices.
Stick with mutual funds until you have money to burn
Reality is that you probably don’t have the time to dedicate yourself to learning and understanding everything that goes into creating a cohesive portfolio that weeds out individual stock risk. So let someone else do it. Use mutual funds as your primary investment vehicles. If you just can’t help yourself, then wait until you have maxed out your 401k, Roth IRA, and emergency fund; paid off your debt and have a bunch of money invested in a normal trading account, then take 5% of your portfolio and play.
Until then, diversify.
Let me know in the comments if you agree or disagree.