Watch for Signs that Stock Investments are more Risky than Necessary

After the worst ten years of stock market investing ever, most investors are more aware of the risks of investing in stocks than they were at the end of the last century.

Recognizing the risks involved in stocks is a healthy development. However, while it is important to be aware of stock market risk, the bigger challenge is trying to manage that risk.

The most common responses that investors have to a volatile market are often not the best.

Many choose to reduce their stock market risk by moving out of the stock market and into cash and bonds. During 2002 and 2008, unprecedented amounts of money were withdrawn from stock mutual funds.

Historically, that has tended not to be the best move. Even during the worst periods of stock market decline (e.g., Great Depression, early 1970s), stocks have delivered better long-term returns than fixed-income or other publicly traded investments. It is not unreasonable to anticipate the same result in the future, especially with the low interest rates currently offered by fixed-income investments, such as bonds and certificates of deposit.

Another common response is to grimly do nothing. Though often justified by a stoic faith in the stock market, doing nothing in the face of steep market drops can keep us from addressing threats to our portfolios that we have the power to do something about. Many buy-and-hold investors who never re-evaluate their holdings have far more risk in their stock portfolios than necessary.

So what should investors look for when trying to reduce unnecessary risk in their portfolios? For starters, stock market investors should scrutinize their holdings for the following “red flags”:

Compare the results. During the sharp market drops of 2002 and 2008, many U.S. stock funds dropped significantly more than the market on average. This may be because the portfolio is concentrated in certain industries or focused on an inappropriately narrow strategy. Though the benchmarks will not illuminate why a portfolio needs attention, they can help investors recognize when something is awry.

Reduce concentrated holdings. One of the most common risk traps of stock market investing is putting a high percentage of an equity portfolio in one company. Though the stock market as a whole rarely loses more than 40 percent of its value, it is not at all uncommon for the stocks of “blue chip” corporations to lose 60 to 80 percent, possibly 100 percent, of their value.

Experts vary on how much of one stock is too much, but few mainstream professional money managers will allow one stock to account for more than 8 to 10 percent of their clients’ portfolios. Most will not allow one company to constitute more than 4 or 5 percent of their portfolios — no matter how much they favor a particular company.

Invest in multiple sectors. Even if a stock portfolio avoids heavy concentration in particular companies, it may expose its owner to undue risk if its holdings are concentrated in only a few sectors of the economy. Just as individual companies can suffer much higher than average losses, so can specific industries. Again, there is no precise figure here, but managers of most large mutual funds and pension plans generally avoid having more than 30 to 40 percent in any one sector. Many will not allow any one sector to exceed 25 percent in their portfolios.

There is, of course, no way to eliminate stock market risk, and avoiding heavy concentrations is only one type of factor to consider. Even professional money managers who manage stock market risk for a living saw seen the value of their stock portfolios decrease substantially in 2002 and 2008.

However, the strategies described above are a few of the relatively simple ways to manage stock market risk without either getting out of the market or putting your head in the sand. By paying attention to the basic makeup of our stock holdings, we can avoid adding to that risk — reducing our pain during down markets and positioning us for success when markets start rising.