Investing in stocks is a risky proposition, even if you hold a variety of stocks in various industries. But putting all of your investment resources into a single stock is far riskier, as the value of a single share will tend to swing far more wildly than the values of stock in a diversified portfolio. The losses associated with investment into a single stock can be enormous.
If you are holding a single stock, you will take a heavy hit if the industry that the stock's issuer operates in suffers during broad economic shifts. No matter how well managed your firm, an emerging technology that makes other technologies irrelevant, a natural disaster or a geopolitical event could hit all corporations in an industry and drag down the price of your stock as well. The shares of even the best managed mining firm will fall if the market prices of the gold and silver the firm mines and sells decline, for example. Likewise, an airline can do little to remain profitable if oil prices skyrocket.
Management teams are human, and their brilliant track records do not guarantee continued prudence and wisdom. Even if you picked the right industry for growth, you might have invested in the one company that failed to take advantage of industry trends. While all mining stocks prosper as a result of advancing precious metal prices, your firm might have committed to sell its silver at a below-market price with long-term, binding contracts. Such contracts protect the seller against price drops, but they backfire if the price unexpectedly rises. Similarly, an airline might have locked in what it thought would be a great fuel price months in advance and pay more for fuel than any of its competitors when fuel prices drop.
If you invest your entire stock portfolio in a single stock, you can lose everything if an earthquake, tornado or flood hits your company and drags down its share price, even if management did everything in its power to prevent a loss. Insurance policies rarely compensate the insured firm for all the lost revenue that results from a natural disaster. Even when natural events aren't the culprit, the mistake of a single worker can do irreparable harm to a company, as when an inattentive line worker in a cannery poisons consumers. Such rare events will harm you far less if the stock is one of several you have in a portfolio.
The risks plaguing a single-stock portfolio can be largely avoided by diversification. A portfolio is diversified if you are holding several stocks representing companies in various industries. The precise number of stocks you should hold depends on your investment goals, risk tolerance and prevailing market conditions. However, a broad rule of thumb is to buy shares of a few competing firms in each industry you pick and have firms from several industries in your portfolio. This way, the mistakes of a particular management team or events that plague an entire industry will only hit a portion of your portfolio.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.