Rules of the Game: Spread Out the Risk

 | Apr 22, 2013 | 11:00 AM EDT  | Comments
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Stock quotes in this article:

rax

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aapl

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regn

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celg

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mpc

Owning a single stock is usually a riskier proposition than owning the broader market, or at least vs. owning ETFs pegged to a more or less plain-vanilla index. When markets are in rally mode, investors can often conveniently forget about single-stock risk.

But sometimes a stock will defy the market's trend. When it rises as the indices are in free fall, an investor may think he or she has made a brilliant call. Of course, things get dicey when you are holding a stock that's plummeting as the major indices are heading north.

That's what recently happened to a friend of mine who owned Rackspace (RAX) shares. Her overall portfolio performance failed to keep up with the S&P 500 even though the benchmark index has advanced for six months in a row, from November through March.

Rackspace, meanwhile, rallied to a new high in January, but tumbled 26% in February, another 9.6% in March, and another 10.8% so far this month. As you can easily see, that hurt her overall portfolio in the first quarter. Although she had originally liked the idea of holding a stock with good potential in the cloud-computing space, she understands how it has hurt her.

The same can be said for anyone with too much exposure to any one stock. Ask Apple (AAPL) investors how that's worked out lately.

Of course, I understand that people like to hold stocks. It's more fun to chat at a cocktail party about Regeneron (REGN) or Celgene (CELG) than to say, "Well, I own the SPDR S&P 500 (SPY)." Yawn.

Those stocks I just cited are a couple that have proven to be big winners so far in 2013. But these outsized gainers can also turn tail very suddenly, as we just saw with Rackspace. Marathon Petroleum (MPC) is another recent example of a stock that rallied to a new high, and then reversed sharply lower.

So what is the best way to mitigate your risk that a huge pullback in one stock will put an outsized dent in your portfolio? Naturally, one way is a basket of stocks, such as an ETF. Allocating to several low-cost indexed ETFs mitigates that risk even further.

But let's come back to the question of individual stocks. We do run an equity portfolio of individual stocks, although it's not appropriate for every client. Even in cases like this, as mutual fund managers know, it's crucial to allocate carefully to ensure no single stock or sector has too big an impact on the downside. Our largest sector holding, just by a hair, is the industrial space. Other top sectors are consumer defensive, energy, financials, healthcare and technology. We currently hold a 15% position in cash.

I've recently been very focused on the idea that single stocks are risky if a particular investment is weighted too heavily. I was reminded of this a few days ago when Dave Ramsey, a personal finance talk-show host, cautioned a caller against buying into one of those "can't miss" trading strategies.

In recent stories I've been highlighting some of our equity portfolio holdings, so later this week I will follow up with our take on some of the sector holdings, and update our view now that earnings season is in full swing.

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