Typically, higher volatility implies higher risk. Since stocks are more volatile than bonds, stocks are viewed as riskier. Thankfully, there are ways to reduce the risk of your stock portfolio.
Diversification is the easiest way you can lower the risk of your stock portfolio. If you only hold two stocks, you’re not very diversified. Assuming you hold an equal amount of money in each, if one goes bankrupt, you lose half of your portfolio.
Studies show that a portfolio of 12-15 stocks is enough diversification. However, the number of stocks you hold should be a number that you feel comfortable about. If you sleep better at night with more stocks, so be it.
The idea about diversification is that you are investing in different industries, so if one industry is not doing well, you still have stocks in other industries that are not doing so bad. You shouldn’t have a huge amount of capital in one sector. For example, if you only bought energy companies such as Husky Energy Inc. (TSX:HSE) in the past year, you would have experienced double-digit losses.
When we diversify, we should be careful not to “diworsify” by buying poor businesses. “Diworsifying” is when you seemingly diversify into different stocks, but your portfolio isn’t doing well because the stocks are correlated so they move in the same direction. You might be diversifying into different stocks, but the quality of the stocks you have is low.
You can achieve diversification by sticking to quality companies.
Stick to quality companies
By sticking to stable, quality companies, you won’t diworsify. What is quality? To me, quality companies have strong balance sheets. You can identify quality companies by looking up their credit ratings from firms like S&P.
Husky Energy has an S&P credit rating of BBB+. If you want to stick to quality companies, look for stocks with ratings of at least BBB+. The higher the rating, the stronger the financials of the business, and the less likely it’s going to go bankrupt. The highest rating is AAA.
In my opinion, stable businesses are companies whose earnings are predictable. For instance, utilities like Fortis Inc. (TSX:FTS) generate much more stable earnings than Husky Energy.
Fortis is a regulated utility that provides needed services of electric generation and natural gas distribution. On the other hand, Husky Energy’s earnings are more or less based on the underlying commodity prices, which are volatile. Fortis has an S&P credit rating of A-.
By holding a group of quality stocks that have strong balance sheets and credit ratings, whose earnings are stable and predictable, you reduce uncertainty and volatility.
In doing so, you lower the risk of your stock portfolio. The trade-off is that you won’t get the highest returns, but you get a more stable portfolio with steady growth.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Kay Ng owns shares of FORTIS INC.