Friday, September 05, 2008

Why It's Wrong to Hold Too Much of One Stock -

Why It's Wrong to Hold Too Much of One Stock - "hey think they're reducing risk and optimizing gains by following the adage, 'Invest in what you know.' Yet too much concentration in one stock actually increases risk...

David Hirshleifer, a finance professor at the Paul Merage School of Business at the University of California, Irvine, says people have a natural tendency to like things with which they're familiar.

"We treat things we're used to as friends.""

"..a report released earlier this year by Citi found that a portfolio should have 25 to 30 stocks to minimize stock-specific risk. It found that only one in 10 stocks consistently outperformed the Standard & Poor's 500-stock Index over the past 20 years in any three-year period. Additionally, a third of the stocks in the index underperformed the overall market by at least 15% or more at any given year. Mr. Munshower says it isn't unusual for high net-worth and ultrahigh net-worth clients to have high concentrations of one stock in their portfolios. "It's very hard for people to sell a concentrated position...""
If there is one thing finance can teach us it is to diversify our investments. While diversification will not eliminate risk (systematic risk is still going to be a problem in most cases), diversification will reduce risk.

How important is diversification? It is the the second most important piece of investment advice I give my family and friends. The list?
  1. Invest early and often to let compounding work in your favor.
  2. Diversify! Across asset classes and across different investments. (remember not all investments are made in financial instruments-education is also an investment, so too is your health).
  3. Transaction Costs matter: keep them low!
  4. Make full use of any tax-advantaged plan.
  5. Automate your savings so you do not need to worry about them. (also what you never had you will not miss).
  6. Do not panic. Think long term. Ups and downs happen.
  7. Live below your means.

1 comment:

Ab! said...

I recently wrote something similar on my blog, particularly on what should average investors do at these times.