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Investing basics: don’t buy just ONE stock

Ruth Saldanha  |  26 Jun 2020Text size  Decrease  Increase  |  
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A recent Tweet by Christine Benz, Morningstar's director of personal finance, generated a fair amount of conversation – and a little controversy. 

Tweet

She’s absolutely right. If you’re just starting your investment journey, or even if you're at any other stage in your investment life cycle, it IS a terrible idea to put all of your money into a single stock. Remember the story about the girl who put all her eggs in one basket, and then tripped and fell, breaking and losing all of her eggs? There’s a reason you ‘Don’t put all your eggs into one basket’. And putting all of your savings into one stock is the same thing – but for investing.

To make sure you don’t lose ALL of your eggs if you trip and fall, you need to put your cache of eggs into different baskets. This process of dividing your savings or investable income or assets (the eggs, if you will) into different asset classes like stocks, bonds or real estate (these are the baskets – though there are more than these) is called ‘diversification’.

Diversification is critical for long term investment success, and to ensure the safety of your portfolio.

Investing’s free lunch

Morningstar Canada’s director of research Paul Kaplan called diversification the one "free lunch" in investing because by diversifying, investors can reduce risk and possibly improve performance.

“Imagine that a portfolio's return fluctuated between -15 per cent and 25 per cent so that the average return is 5 per cent. Over time, the compound rate of return will be about 3.1 per cent. Now suppose that through diversification, it was possible to create a portfolio with returns that fluctuate between -5 per cent and 15 per cent. The average return of this portfolio is also 5 per cent, but the compound rate of return will be about 4.5 per cent. This illustrates the mathematical truism that if two portfolios have the same average return, the one with lower volatility will outperform. Hence, any opportunity to reduce volatility without reducing average return should be taken,” Kaplan explains.

MORE ON THIS TOPIC: your guide to diversification

Put another way, if you spread your assets into different asset classes, you reduce volatility. This is because different asset classes and different markets do not move in lock-step. For example, when stocks go up, typically, bonds would go down. So by diversifying into different asset classes, even if one portion of your portfolio falls, the others are there to prop it up.

“Just look at the past three major market corrections in Canada excluding the pandemic (tech bubble, Asian currency crisis, and the financial crisis). During these extreme market events, equity funds fell the hardest, bonds fell the least, and allocation funds (those that held a mix of stocks and bonds) were somewhere in between,” points out Ian Tam, Morningstar Canada’s director of investment research.

Where should you invest?

With thousands of individual stocks, funds and exchange-traded funds, the task of deciding where and how to invest can seem daunting, but Benz urges investors to resist the urge to overcomplicate and/or to venture into overly narrow investment types.

“Instead, focus on low-cost, broadly diversified investments," she says.

If you don't want to delegate control of your portfolio's stock/bond/cash mix and investment selection, a simple way to put together a well-diversified portfolio is to employ index exchange-traded funds. Such funds track a segment of the market, such as the S&P/ASX 200, rather than trying to beat it. That may sound uninspired -- and uninspiring. But broad-market index funds often have the virtue of very low costs, which can give them a leg up on actively managed funds over time. If you do opt for actively managed funds for all or a part of your portfolio, low fees should still be a key priority,” Benz notes.

MORE ON THIS TOPIC: How to build a simple, diversified portfolio with listed products

MORE ON THIS TOPIC: What is an ETF

Investors sometimes think that owning multiple of the same funds is the way to diversify. But that is not true.

8 equity funds = diversification?

We recently had an investor reach out with this comment:

I have more than a decade until retirement, and I agree that diversification is essential. That is why my portfolio is spread among eight equity funds!

The investor was pleased with his diversification, but the fact is, a greater number of funds does not mean you are diversified. His entire portfolio consists of only eight equity mutual funds, which means that all of his assets were in one asset class – equities. He is not fully diversified across different asset classes (stocks, bonds, cash, alternatives)

“You might also not be geographically diversified if all eight funds are invested in one region (for example, North America). An easy way to find out what your funds are holding is to have a look at the Morningstar Category they belong to. These are standardised fund categories for the market and will give you an idea of geographic exposure, asset class, and style of investment. If all of your funds are in one category, that is a good warning sign for you to consider diversifying your investments,” Tam says.

MORE ON THIS TOPIC: Diversify, but not too much

The Morningstar portfolio and X-ray tools also fulfill this function, giving you an idea of what asset classes, sectors, styles and regions your portfolio is exposed to. 

Easier ways to learn

Going back to Benz’s tweet, she followed it up with two more.

Tweet

The main counterpoint to her idea was that by investing in individual stocks, young investors learn valuable lessons, even if they fail. While it is always good to learn, there are easier and less costly ways to do so.

If you do want to invest in a single stock, do your homework. Understand why you’re investing in the stock, what the company does, what it’s growth plans are, how much money it has right now, how much money it will make, and also, crucially, if it makes sense for you to invest in the company at the current price.

If, after you understand all of this, and you understand the risks of investing in a single stock, you want to go ahead, then you’re making an informed decision. If you’re caught up in the excitement of something that everyone else is doing, it could be that you’re looking at a bubble.

Morningstar’s head of behavioural science, Stephen Wendel says an individual investor should arm oneself with a narrative, beforehand, to understand other people’s excitement. For example, much of that excitement may be because people feed off each other’s excitement, and that has little to do with the underlying fundamentals. That’s a valuation-driven narrative.  But other – accurate – narratives could also work, from other investing philosophies, he says.

Wendel suggests two tools – externalising and friction: “Externalising means to thoughtfully write out your own personal investing rules, when you are in a calm state, and then use the written version to guide your day to day actions. This is a tool to avoid using your (malleable) intuitions and emotions in the moment. Friction is all about slowing you down: making it harder to act rashly in the moment, so that you might return to the issue with a calmer head.” 

is senior editor at Morningstar.ca

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