In my last column, I reported on recent academic research showing that it takes many more stocks than most investors think to reduce risk in a portfolio (see
"How many stocks do you need?"). For decades, everyone has thought that around a dozen stocks would do the trick, but the latest thinking suggests you need 60 stoc
ks to reduce 90 percent of a portfolio's volatility.
If the blizzard of e-mail I received is any indication, people aren't exactly happy with those findings. The most common argument is that volatility has nothing to do with risk. As David Fox protested: "The notion that high volatility is tantamount to hig
h risk is nonsense. Who cares about short-term fluctuations when what really matters is what you paid vs. what you receive at the end?"
Now that's mostly true -- but only if you can afford to own your stocks for as long as you intended. To see what I mean, imagine two investors who each buy a different stock that turns out to have a 10 percent average annualized return. One stock earns th
at 10 percent like clockwork, while the other has more mood swings than Calista Flockhart. Let's call the stable one Smoothie, Inc. and the jittery one Coronary Corp. Here's how they look:
Volatility does matter
As you can see, if you had put both stocks away in a safe-deposit box for 10 years, the end result would be identical: A $10,000 investment in each would have grown to $25,937. But what if you needed your money back early? Smoothie was worth nearly $4,000
more than Coronary after Year Five and almost $13,000 more at the end of Year Nine. That's why, for most investors, volatility does matter: We may need to dip into our investments at that unforeseeable moment when their values are at their very worst. Th
e fewer stocks we own, the more dangerous that moment becomes.
That, though, wasn't the only source of disagreement. Some investors also worry that diversification will doom them to average returns. As Stu Cairns put it: "I think you've missed the point. The whole point of investing is not to pick stocks at random bu
t to pick companies that will do well." And adds Dave Arneson: "Would you agree that the more stocks you own the less chance you have of large gains?"
It's true that focusing your research efforts on a few stocks can lead to big wins. But it also increases the odds that you'll end up with terrible results, simply because you might pick the wrong investments -- and because even a single loser can wipe ou
t a concentrated portfolio. If you own only a few stocks, you have to get every one of them right. That's asking a lot of yourself.
If you can't resist the stock-picking bug, the best way to cope is to make a total stock market index fund your core holding. Then, with whatever money you have left over, you can take a flyer on a few stocks without undue risk. That way, you'll still hav
e most of your portfolio spread across the entire U.S. stock market. That gives you the best of both worlds: All the fun of trying to outperform the market with a little bit of your money, but no chance of blowing your retirement savings if your stock pic
ks stink.
|