You’ve probably heard some stories about some dude getting unbelievable returns from investing in just one stock. Does GameStop ring a bell? So now, you’re considering doing the same. Or you might have done the same, wishing to have the same returns. But, if that’s the case, you need to think twice, thrice or as much as it takes since you are probably taking more risk than you know.
Investing in only one stock exposes you to enormous risk of losing your money. Companies face the risk of going out of business or suffering significant financial loss. As a result, your investment could lose a lot of, if not all, of it’s value.
Now, you might be alarmed, and I get it; Let us examine further why it is a terrible idea to only invest in one stock. what are those risks? And how can you hedge against it?
How does the market value of a stock move?
Before investing, we should all know that the stock moves up or down based on supply and demand. So, when more people are more willing to buy a stock than sell it, the value will go up. And when more people want to sell the stock than those willing to buy, the value goes down. But, of course, this also holds true for different kinds of investments.
Factors that could send the value of your investments in a downtrend
There are two main types of risk when you are investing, namely:
- Systematic Risk
- Unsystematic Risk
Systematic Risk
The risk inherent to the whole market is called systemic risk, more commonly known as “Market risk”. It is characterised as unpredictable and non-diversifiable hence, whether we like it or not, it is a risk that comes with investing. Examples of this would be interest rates, inflation rates, war, and political unrest. It is a form of risk that all investors have to live with. As the saying goes, there’s no free lunch. Rewards always come with risks.
Unsystematic Risk
The unsystematic risk or Company-Specific Risk is a unique risk to a single company or an industry. Unlike systematic risk, company-specific risk could be avoided through diversification. Which is great, don’t you think? So, what are the common events that drive these risks?
- Political and Legal Risk. A new legislature could send the value of a company down. For example, they have banned a material used in a company you are invested in. This can snowball into few other things like bad reputation or operational problem which could lose the confidence of the investors.;
- Management Issues or bad entrepreneurship;
- Disappointing financial performance; and
- Scandals and accidents.
Now, I guess you’re wondering how you can minimise the risk of plummeting the value of your portfolio as well as reducing the risk of your sleepless nights and the growth of your white hair? Well, you’re in for a treat. The answer? Diversification.
Let’s have a quick round of discussion over the basics of diversification.
What is Diversification
It is an investment strategy of putting your money in an array of investments. It indeed is an effective way of minimising the unnecessary risk associated with only investing in one stock.
Rather than putting all your eggs in one basket in layman’s terms, you spread it in different ones. So, if you dropped the egg, there’s some still available to you later on.
These baskets could be different asset classes, sectors, or even geographies.
Why Should you Diversify
While diversification does not entirely remove the risk associated with investing, like the risk inherent in the market, it does lessen if not thoroughly neutralise the losses you will take if you maintain a single-stock portfolio. The gains you earn from other investments that perform well offset the losses on those that perform poorly. That sounds like a good trade-off, right?
This is also why it is considered as one of the fundamental components of investing. Even Warren Buffet mentioned that he doesn’t think most people are in a position to pick a single stock, and I think this especially rings true if you’re still just beginning to dip your toe in investing.
The Golden rule of diversification
As much as possible, your investment picks should negatively correlate with each other or not be perfectly correlated – meaning it doesn’t move the same way. In this way, even though your one holding goes down, it will be compensated by the increase in the other, or at least not everything will bleed.
Imagine this. You are already a few months nearing your retirement, and you only have a single stock portfolio, and you chose an airline stock because you love going around, travelling. Then, low and behold – COVID-19 happened. Although everything took a plunge, the airline sector is one of the worst-hit and will still probably be in a slump until we are clear of this pandemic. As a result, your portfolio will look as red as it could until this date, and you will probably delay your retirement for a while.
If only you had an investment in a delivery service company, you might have lessened the impact of this event. The increase of demand in deliveries is making their stock climb steadily. If you have both of these stocks, the gain from the delivery company will offset the loss from the airline stock.
SAMPLE
How to Diversify
You might think, “Oh well, I will just have to invest in different kinds of companies or stocks to mitigate those risks.” And man, how I wish it was easy like that, but owning different stocks does not necessarily mean you are well diversified. If you want to eliminate the unsystematic risks that I kept on bringing up earlier, we must diversify. How? Remember those egg baskets earlier? We will now put it to good use. Here are the basic steps in diversifying your portfolio:
Step 1: Determine your risk tolerance, time horizon, and financial goals.
Before diving headfirst into diversifying, you must consider your financial goals, risk tolerance, timeline, and where you are right now in your financial journey. This will point you to what kind of investments fit your needs.
Step 2: Diversify through different asset class.
The most basic way of diversifying your portfolio is by investing in different asset classes or investment types. It could include but not limited to the following:
- Stocks – owning a piece of a company. Earns income either from capital gain or dividend.
- Bonds – pays interest to investors who lend company or government.
- Cash and cash equivalents – cold cash, savings account, short term money market securities, etc.
One typical mix is investing in stocks and bonds at the same time. Since it tends to move differently from each other. Once you have selected an asset class, you could further diversify among the investment.
Step 3: Diversify within the asset class
| Asset type | Diversification within asset |
| Stocks | Industry or sector. Investing in different kinds of industries namely: MaterialsIndustrialsConsumer DiscretionaryConsumer StaplesHealth CareFinancialsInformation TechnologyTelecommunication ServicesUtilitiesReal EstateEnergy |
| Bonds | Issuer. Government or private companies. Maturity. Short-term, medium-term, or long-term in |
| Both | Territory or Geographies. Investing in Domestic, foreign, emerging or developed markets. Type of funds. An exchange-traded fund, index fund, mutual fund. |
Okay. Breathe. Are you still with me? I know diversifying your portfolio could get complicated, especially if you are strapped on time. But there’s a solution! One effortless way of diversifying your investments without putting too much time in individual stocks and bond picking is investing in an exchange-traded fund or index fund and bond fund. These funds act as a bucket for different stocks from various industries. As for the bonds, other types of issuer and maturity terms.
Step 4: Rebalance your portfolio regularly.
Depending on where you are currently in your financial goals or the current state of the market, you should rebalance your portfolio regularly. This means shifting your investments from one to another. For example, you are nearing your retirement, and you’re still heavily invested in stocks. By this time, you should shift your investment to a less volatile asset like bonds. Why? Because when an event like a pandemic hit, your stocks will plummet, and your expected returns will be reduced.
If you want to know a more thorough discussion of diversification and get a glimpse of a real-life portfolio allocation, go ahead and check “Investing: Which Investments Don’t Lose You Money?”
While investing in only stock seems inviting because of the stellar gains you might get, it is not a good idea to go all-in if you are just getting started in investing and does not have the stomach to see your money bleed. Always make sure that your investments are aligned with your financial goals.
Summary
Let’s wrap up the article by going over the things explained earlier –
- Only investing in one stock will expose you to unnecessary risks. More often than not, it works against your odds.
- There two main types of risk. Systematic risk – non-diversifiable and inherent to the market. And unsystematic risk, also called the company-specific risk, could be avoided through diversification.
- The unsystematic risk could be avoided through investing in different asset classes, industry, and geographies.
- Investing in Funds (ETFs, Index Fund, Mutual Fund, etc.) could make diversification easier.