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.

Using “buckets” or multiple portfolios isn’t a new idea. I’ve seen it used for various purposes. The premise is pretty simple but proper use can be very powerful and financially rewarding. Rather than creating one portfolio that is set to mature when you reach a certain age, let’s say 65, create multiple portfolios with different target or maturation dates.

Let me explain using my wife and I as an example. Normally, a couple spends all of their working years putting money away into 401Ks and IRAs with the goal of retiring at age 65. Due to tax laws, we can’t touch the money in those retirement accounts until we reach at least age 59 1/2. So we dutifully invest money for 40 years. As youngsters, we invest aggressively because our time horizon is long and we can afford to have years with losses. But as our retirement date approaches, we move more and more money into safer investments. So our portfolio makes less money as we get closer to retirement. And yet, with the high life expectancies of today, this one portfolio will have to be sufficient enough to last us 20-30 years. But if we are only earning 3-4% each year, then we may run into trouble.

Now let’s consider using multiple buckets or portfolios. We’ll start with just a simple two bucket or portfolio approach. In this example, I expect to live 30 years after I retire at age 65.

• Portfolio 1 contains only one half of all our retirement money and is designed to be available the day we retire at age 65. So again, we slowly move money into safer investments as that day draws near. BUT, we only want this portfolio to last 15 years and then run out.
• Portfolio 2 contains the other half of our retirement money and is designed to be available when I’m 80 years old and the first portfolio runs out. Since I have an extra 15 years to invest this portfolio, I can be aggressive for much longer and earn more money before having to move to safer investments such as bonds.

So the benefit is that through using multiple portfolios, I can be more aggressive where possible and increase my potential return. Now, let’s get a bit more fancy again using my wife and I as an example.

• Portfolio 1 uses only normal, taxable accounts because I want to retire at age 50. So I need to withdraw from accounts where I don’t face tax penalties for early withdrawals. But I only need this account to last 10 years because then I can access my tax deferred (401Ks) or tax advantaged (Roth IRA) accounts.
• Portfolio 2 uses tax deferred or tax advantaged accounts and is designed to mature or be ready to use when I turn 60 and Portfolio 1 dries up. In our case, I want that account to last until we are 70.
• Portfolio 3 may use a combination of taxable and tax deferred accounts because I intend to draw every penny out of it in my 60th year in order to build our retirement home (we plan to do a lot of traveling in our 50s).
• Portfolio 4 is invested more aggressively for longer than any other account because I don’t need it until I’m 70. But then I intend to use this account until the day I die. So it has to last for 20 years.

This may seem a bit absurd or overboard, but so does coupon-ing until you try it and see the cost savings. The goal is to maximize the time that you have and the return that you can earn on your money. Don’t just make your money work for you, make it work smarter for you.

Understand, though, that this bucket approach is a numbers game. Meaning, you have to crunch a lot of numbers to determine how much money needs to be in each account on the day it is supposed to mature or be ready for use, how much money you need to put into each portfolio on a monthly or annual basis, and how much you need to be earning on average in each portfolio in order to meet your goals. So if you are not comfortable running the numbers yourself, please consult a competent financial advisor. I’m a strong advocate of hiring a professional if you need the help.

For a few ideas on selecting an advisor, you can read our post titled 5 Tips for finding a good Financial Planner.

Hopefully I’ve adequately explained the bucket approach well enough that you have at least an idea or inkling of its potential. Please feel free to ask any questions or provide suggestions to others in the comments section below.

Also, you can follow Rabbit Funds on Twitter for more investing and retirement ideas.