Everybody knows a good portfolio should be diversified right? However, this is one of the challenges of investing when you have a stock that is on a tear and has been a long-standing great performer for your portfolio. I recently read a biography on Warren Buffett titled “The Snowball: Warren Buffett and the Business of Life”, and early in Buffett’s investing career he did not believe that diversification was the way to get excess returns and thought you needed to be concentrated in a few positions. His argument was that owning too many stocks and spreading one’s analysis too thin took away the ability to fully understand the company and its management or growth plans. He changed his opinion sometime later after suffering some substantial losses in a few of the names that he owned.
Last week while traveling on the road I had this question on more than one occasion, “I own a large holding up company X should I keep it?” I have a rule that I will generally not subject the portfolio to more than 5% of anyone one position. The only exception to that rule would be privately own stock where you or your partners control the majority ownership and have the ability to assist in a successful outcome.
I believe that no matter what I say or what anyone else tells you, you shouldn’t have one position be more than 5% on your overall portfolio. This is one of the basic risk measures we strive to employ to insure that if we are wrong we won’t stuff in dire consequences. Facebook just over a week ago should be evidence what can happen with any company and the possible benefits of diversifying your portfolio. From what I have read, the earnings report wasn’t terrible for Facebook, however guidance was lowered and some margin compression in the future set traders hitting the “sell” button.
There are many things that can cause great companies to lose a substantial amount of value in one day. Management missteps, new competitive environment, government regulation or maybe even the entire sector falls out of favor just like the tech sector in 2000.
I tell the story often of the manager at Merrill Lynch when I first started that had about 95% of his liquid net worth in the company stock. This guy was in the business of telling people to diversify, yet he did not follow his own advice. Come the financial crisis and what looked to be a nice nest egg was totally demolished after the company was purchased by Bank of America. He ended up working an additional eight years just to have enough money to retire.
Obviously you always need to consider factors such as capital gains restricted stock etc. so there will always be exceptions to the rule however I can’t advise strongly enough that when possible, I believe you should reduce the position to 5% and don’t look back.
As always please don’t hesitate to call with any questions.
Any opinions are those of Mick Graham and not necessarily those of RJFS or Raymond James. Expressions of each opinion are of this date and are subject to change without notice. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Rebalancing a non-retirement account could be a taxable event that may increase your tax liability. Diversification and asset allocation do not ensure a profit or protect against a loss.