Owning Too Much Stock in One Company
8 August 2006A blog called the Island of Dr. Death has a post on how he narrowly avoided a financial disaster by noticing that most of his stock portfolio was in a single company and selling out before a bad earnings report dropped the stock price like a rock.
This is an important lesson for novice investors: never put too much of your money in one stock. If more than 10% of your money is in a single company, you need to sell some of that stock and put it someplace else. One of the key principles of long term investing is diversification – that you’re far better off owning stock in multiple companies than in a single one. This is because if something goes wrong with the one company, you’re doomed with no chance of recovery. If you have a portfolio of stock in many companies, you aren’t subject to as much risk. What are the common reasons people make this mistake?
1) Owning company stock. Often your company will either give you stock or options as part of your compensation, or they will make it very cheap to buy company stock so that it makes a lot of sense to do so. While it’s usually a good idea to buy if you’re getting a discount of some kind from your employer, it is not a good idea to just keep the stock forever. Sell some of it when you can and move it over into other investments. If you don’t, you might find yourself in the situation of Enron’s employees – many of them were millionaires, and within a month or so lost it all because it was all in Enron stock. Many other people lose out on millions without knowing it because they own stock in underperforming companies that don’t grow as fast as the stock market as a whole.
2) Failing to rebalance your portfolio. Every year or so at least, you should look at how much money you have in each investment and “rebalance.” This means you move money around to meet your ideal portfolio mix. It’s a good idea to decide that you want a certain amount of money in certain investments – you might decide you want 20% in municipal bonds, 60% in stocks or mutual funds, and 20% in real estate investment funds or mutual funds that invest in them. How you should balance is a topic unto itself and will have to wait for another post – but the point is that you should have a set amount in mind for what you want your portfolio to look like. Over time, however, these numbers tend to get out of whack. Your bonds won’t grow that much, and your stock will grow faster – so if you sit around and don’t do anything, after a year you might have 10% in bonds, 65% in stocks, and 25% in real estate.
The solution is to sell some of the stocks and some of the real estate and put it back into bonds. The bonds are there to make your portfolio less risky and more stable, the stocks are there to grow quickly. And when they grow faster, you need to prune them a little and put the money someplace else. This is especially true for people who own a lot of one stock. Even if that company’s stock has doubled or is doing really well, you need to sell some of it so you don’t end up with most of your money in that stock. For every Walmart or Home Depot, there’s an Enron or Global Crossing that grows really fast and then collapses.
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