09 Feb The risk of stocks vs. mutual funds

Q. My parents are generous and they give me stocks for my birthday. I have a nice portfolio now but I know it’s not diversified. I think I want to sell and invest it all in mutual funds, but my dad says I should keep the stocks. How do I handle this?
— Faithful kid

A. Your question is very timely given the ugly week we’ve seen for the stock market.

We understand this could be a tough conversation with your dad, but this is a great opportunity to chat about diversification and how it fits into your money goals.

Here are some examples you can use to start the discussion.

“In the financial industry we say, ‘Diversification is the only real free lunch,’” said Frani Feit, a certified financial planner with Tradition Capital Management in Summit. “What that means is that if you have one stock with a 7 percent return compared to a portfolio of four stocks each with a 7 percent return, you will get the same return from the four-stock portfolio but the standard deviation — risk — of this portfolio will have decreased due to diversification.”

Feit said there are situations where if you held a stock for multiple decades you would be richly rewarded.

Exxon is one example. Back in 1970, the stock traded at $1.70. After five stock splits that were each “2 for 1,” meaning investors got two shares for each share that was held, you would have more shares today of a stock that trades at $89.

But on the other side are companies like Enron, Feit said.

“In mid-2000, the stock traded at $90.75. By the end of November 2001 Enron was at $1 before the company declared bankruptcy. Ouch!” Feit said

Or you can look at General Electric, which Feit said tells the story of a relevant company price downturn.

She said if your dad worked for the company in mid-2000 and had gotten stock, the price was $60. Had he given you one share, your market value today would be $16 — a loss of $44 per share. GE is a household name and yet this decrease in value greatly hurts your total return in a small stock portfolio, Feit said.

When an individual buys a diversified equity mutual fund or exchange-traded fund, he will get broad market exposure among different sized companies and industries without the worry that one of the stocks held will crash, Feit said.

She said you can even purchase diversified equity funds by size, such as large-cap or small-cap, value or growth, for additional diversification.

“Your dad is not wrong in thinking that individual stocks held in a diversified 40 to 60 stock portfolio are a great investment, especially for high net worth investors as losses can be harvested against gains; the stocks with low cost basis can be donated thereby eliminating any capital gains, and socially conscience — known as ESG — needs can be customized to the investor’s desires,” she said. “But investing combines looking at a risk-return matrix and until a portfolio can be sufficiently diversified, you would be smarter to sell and buy a broad market fund.”

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This post was first published in February 2018.