The Biggest Risk to Your Portfolio
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
We have all heard the horror stories about people who lost all their savings due to a dramatic decline in stock prices. The possibility of facing such a risk can sometimes be really threatening, and even paralyzing for many investors. However, there is really no sound basis for such a concern if your portfolio includes a healthy dose of diversification and is managed with a long term perspective. After all, the biggest risk of all is following an inadequate investment strategy.
Companies can enter a long lasting spiral of declining sales and profits, and even go bankrupt in the end. That is called “specific risk,” the risk that the company in which you invested may get into serious trouble and deliver a serious blow to your portfolio. The business world is inherently dynamic and always changing, so innovation cuts both ways: it can be a powerful source for profits, but it can also generate serious losses when a competitor enters the market with a better, perhaps more innovative, product.
Research In Motion (NASDAQ: BBRY) was the first mover in the smartphone arena with its BlackBerry devices which were tremendously popular, especially in the corporate segment, since the beginning. The company amassed big profits from this innovation and it seemed like a clear winner for quite some time. But innovation kept its course, and the most disruptive products didn´t come from RIM over the following years.
Apple (NASDAQ: AAPL) introduced the iPhone, and it gained a lot of market share away from RIM in the high end of the market. And Google (NASDAQ: GOOG) launched its Android operating system for smartphones, giving it away for free with the idea of securing its position in search, maps and other businesses.
Android became the preferred platform for many smartphone manufacturers, since it gave them access to an enormous ecosystem which wouldn´t be available for them on their own production scale, so Google and Apple delivered a tremendous blow to RIM and its shareholders.
Apple and Google are now the two biggest contenders in the smartphone industry, and Google is entering the tablet markets too. Holding a position in both companies can diversify away the risks in case one of the two giants widens its advantage over the other in the following years. As a general principle, investing in different competitors in the same industry notoriously reduces the risks of big and permanent losses.
But industry risk still remains a factor to consider in that case. A portfolio comprised exclusively of technology stocks could suffer from serious drawbacks in a scenario like the tech bubble of 1999/2000. The financial crisis of 2008/2009 serves as a painful reminder of how expensive it can be to excessively concentrate in one industry.
Bank of America (NYSE: BAC) and Citigroup (NYSE: C) are two dominant players in banking, so investors could have reasonably assumed that a position in both institutions would reduce competitive risk. There is some truth in that idea, but when the banking business goes through such an explosive crisis, there is still a big risk of permanent loss of capital, especially considering how much leverage these companies carry on their balance sheets.
Unlike specific risk, industry risk cannot be avoided by investing in different companies in the same industry, investors need to put their eggs in different baskets, and that means different companies as well as diverse industries.
On the other hand, even the most diversified basket of stocks can suffer significant damage when the market enters a profound bearish stage. Such was the case of the last recession, for example, in which not even diversifying among stocks and industries would have avoided the fall. That´s when time horizon becomes really important and long term thinking can be the best ally of an investor.
After all, bear markets come and go, and the economy always has its recessions and expansions. If you are patient enough to increase your positions at times of pessimism, bear markets can become an opportunity to buy high quality stocks at discounted prices. Market risk cannot be diversified away, but a long term mentality can transform that risk into an opportunity for better returns.
As long as your portfolio is well diversified, and positions are managed with a long term mentality, there is no reason to fear the possibility of a permanent collapse in the value of your holdings. The biggest risk to your portfolio can be an inadequate investment strategy, and the good news is you can avoid that risk with patience and diversification.
acardenal owns shares of Apple and Gogle. The Motley Fool owns shares of Apple, Bank of America, Citigroup Inc , and Google. Motley Fool newsletter services recommend Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.