We can thank Facebook (FB, $168.15) for giving us a good lesson on the value of diversification in the stock market.
When Facebook’s stock dropped 6.8% on Monday, March 19, following news that information on more than 50 million users was accessed without the social platform’s consent, the investing public let out an audible gasp. After all, Facebook and other tech and social media giants make their money on collecting and using user data – your data. If they cannot keep it safe, then users may no longer give it to them.
This isn’t the same kind of breach as the one that rocked credit reporting firm Equifax (EFX) last year. In fact, Facebook claims it wasn’t technically a “breach” at all, but that hardly makes it any better – and in fact, the idea that this was just so close to the normal run of business may be even worse. Breach or not, the unauthorized use of Facebook’s data still took its toll on the public trust.
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More importantly for investors, it sparked Facebook stock’s largest sell-off since 2014 and shaved $36 billion off its market valuation.
The woes in FB started a cascade lower in other big-name tech stocks such as Nvdia (NVDA) and Google parent Alphabet (GOOGL). Facebook’s large market capitalization dragged major market indexes lower, too. Most indexes are capitalization-weighted, meaning that the bigger the stock, the greater its effect on the index’s movements.
The question for investors is how to protect your portfolio from future blow-ups in this or any other stock.
The answer: The age-old technique of diversification. While it does not guarantee that you won’t lose money, investment pros agree that it is a key piece in long-term investment success.
What Is Diversification?
We all know there is risk in the stock market. Diversification ensures that you do not put all your proverbial eggs in the same basket. You spread that risk around so that some portions of your portfolio react differently than other when, say, interest rates spike higher or there is a shortage of energy.
Let’s be clear: A diversified stock portfolio still will get hurt in a bear market. That’s called “systematic risk.” The only way to combat that is with assets that do not correlate with stocks, such as gold, bonds, real estate and more exotic types of investments.
The current problems with Facebook illustrate what is called “unsystematic risk.” This is the risk associated with an individual company or even an entire industry group in the market.
For example, in the weeks and months following the Sept. 11, 2001, attacks, airline stocks as a group suffered tremendously. Precious metals miners started to rally. And after a few weeks of volatility, food stocks and many others started rallying, as well.
Fast forward to the financial crisis in 2008, and bank stocks suffered the brunt of the selling while biotech barely hit a speed bump. For each market-rocking crisis, some sectors fare better than others.
Many investors have Facebook in their portfolios, either directly by owning the stock outright, or indirectly through exchange-traded funds (ETFs) and traditional mutual funds. Indeed, technology is the largest major part of the stock market, with a 25.2% weighting in the Standard & Poor’s 500-stock index, according to S&P Dow Jones Indices.
ETFs and mutual funds by definition offer diversification. They invest in dozens, hundreds, sometimes even thousands of stocks, so in many cases, a big drop in any holding does not equate to a big drop in your fund.
However, FB and several of its cousins are very large stocks and do create exceptional problems here.
For example, let’s say you own the Technology Select Sector SPDR ETF (XLK) because you believe technology is a key, long-term growth area. The ETF holds 73 stocks, but Facebook represents 6.5% of the weight. Toss in Nvidia at 2.4% and Alphabet at 10.5%, and these three high-profile Monday decliners represent 19.4% of the ETF.
That is not exactly diversification, is it?
Diversifying by Rebalancing
Clearly, investors must do their homework when adding these supposedly diversified instruments to their portfolios. Some are good, but other are not really diversified at all.
If you are one of the many Facebook owners, or any of the hot tech stocks of the day, including the FAANGs – Facebook, Amazon.com (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (formerly Google) – you need to determine just how large these holdings are in your portfolio.
First, let’s state up front that these stocks remain the growth engines in the economy. Therefore, owning a small piece of them is still a good idea. However, Facebook gained 53.4% in 2017, making what you thought was a balanced portfolio in January a lot less balanced in December.
That’s obviously not an entirely bad thing. We want lots of growth. The problem is that a portfolio can grow in one area and not in the other. When that happens, you become too dependent on the performance of just a handful of stocks.
You can pick one day per year to bring your allocations back in line with your original plan, or you can do it monthly like many institutions. Just be careful that you don’t take too heavy-handed an approach.
Simply trimming your holdings in a winning stock that you think will continue to climb, only to add to holdings of lesser performers, goes against the old investing saw of letting your winners run and cutting your losers. Therefore, you should consider other factors, including whether your winners still look sound fundamentally and even technically. If they do, perhaps cutting back only just a little would be the best plan.
Even better, if your analysis turned up a stock that is just starting to outperform, you can trim your previous winners a bit more to add to the next rising star.
The bottom line is that you need to pay attention to your portfolio, at least every few months, to be sure it is not getting concentrated in just a few names. Small adjustments every now and then can help protect you from single-stock or even sector-wide selloffs in the future while still letting you participate in their long-term gains.