Don't Sweat the Small Stocks

Don't Sweat the Small Stocks

by Thomas L. Hardin

People spend more time watching, worrying, and getting excited about individual stocks than any other part of investing. They read the market reports, track charts on the Internet, and work themselves into a frenzy because "this stock's up and that one's down." The truth is, in a diversified portfolio that includes cash, bonds, and an assortment of stocks, individual stock performance makes up only a very small part of the total return.

Instead of agonizing over individual stocks, experienced portfolio managers know that the two most important components in creating a diversified portfolio are asset allocation and sector weighting.

  • Asset allocation refers to the percentages of stocks, bonds, and cash in a portfolio. Studies show that the optimum number of stocks to own is between 12 and 20. If you followed this advice and had 15 stocks in your portfolio, and your portfolio was 60% stock, each stock would make up 4% of your portfolio. A 50% advance or decline in one individual stock would have only a 2% impact on the portfolio's overall performance. A properly balanced and diversified portfolio takes the worry out of investing.
  • Sector weighting, the second key component in successful investing, means deciding how much money to invest in a sector, which is a group of similar industries. (For example, the transportation sector would include air freight, airlines, railroads, and trucking.) When you overweight a sector, you invest more money in that sector; when you underweight a sector, you invest less. In 1999, an overweight in the technology sector generated high returns while the financial sector performed very poorly. In 2000, technology stocks crashed while financial stocks outperformed most other segments of the market. Investors who profited in these situations knew how to utilize the concepts of sector weighting and rotating or shifting sectors.

Smart investors don't get too emotional about individual stocks, hanging onto underperformers because of sentimental attachments. It's okay to be sentimental about a company but not about the stock. Companies and stocks are two different things. In my view, stocks are just cogs in the wheel. Instead of clinging to underperforming stocks, smart investors live by the rule "cut your losses short and let your profit run." In other words, if a stock begins to move downward, the smart investor sells it and replaces it with a stock that has stronger technical and fundamental indicators. This technique also makes good tax sense: Stock losses can be written off against gains.

There are times when a portfolio should contain a higher percentage of stock, and times when it should have less. There are times when you should overweight one sector and underweight another. That's why smart investors go through a process to clearly define their investment objectives, quantify the risk parameters, and develop a disciplined, rules-based method of investment management. Then they can leave their emotions out of the picture and forget all that watching and worrying about individual stocks. If you'd like more information on developing a rules-based system or any of the other topics mentioned in this article, please contact the financial professionals at Canterbury Financial Group.