There are two ways to get diversification wrong: owning too much of one company, and owning many funds that hold the same things.
The mistake
Concentration often builds up without a decision. Stock awards vest, an employee stock purchase plan buys more every quarter, and one company slowly becomes a large share of what you own. At the other extreme, a portfolio of many funds can look diversified while most of them hold the same large companies, at several layers of cost.
The evidence
J.P. Morgan studied about 13,000 stocks that were in the Russell 3000 index at some point from 1980 to 2014. Roughly 40% suffered a permanent decline of 70% or more from their peak, and about two-thirds underperformed the index. (J.P. Morgan, The Agony and the Ecstasy, data through July 2014)
Employer stock carries a second risk. If your salary, bonus and stock awards all come from one company, a bad year for that company can hit your income and your portfolio at the same time.
What to do instead
- Measure your largest single holding as a share of everything you have invested, including vested stock awards and stock bought through a purchase plan.
- Set a limit in writing for any one company, before you need it.
- Sell down on a schedule, for example as awards vest, and check the tax cost first (mistake 6 covers taxes).
- Check your funds for overlap: compare their ten largest holdings. If the same names keep appearing, you are paying more than once for one exposure.
- Prefer fewer, broader funds over many narrow ones.
The tool: a five-minute concentration check
| Check | Your answer |
|---|---|
| Largest single holding, in dollars and as % of all investments | |
| Employer stock: vested shares, purchase-plan shares and unvested awards | |
| Your written limit for any one company | |
| Number of funds you own | |
| Companies that appear in the top ten of more than one fund | |
| Expense ratio of each fund |
How this is handled in practice
Portfolios are built as a diversified allocation matched to your capacity for risk, one of the three sides of risk in mistake 2. Investment management is offered through Gwynedd Wealth Partners, LLC.
Series · Ten common investor mistakes
- Whose plan are you following?
- Capacity, willingness and requirement: the three sides of risk
- Too concentrated, or too diversified?
- Why popularity makes value harder to judge
- The best days sit next to the worst days
- What you keep, not what you earn
- Do you know your real return?
- Plans fail quietly
- Five checks before you hand anyone your money
- Your savings rate: the lever you control
This article is for education and is not a recommendation to buy or sell any security. Past performance does not guarantee future results. Investment advisory services are offered through Gwynedd Wealth Partners, LLC.