When you purchase individual stocks, risk is inherent. Sometimes bad things sometimes happen to good stocks such as the Chicago Tylenol murders of 1982. This shook Johnson & Johnson’s (NYSE:JNJ), but eventually it prevailed. Sometimes it is difficult when a strong leader leaves a company and creates a void that just can’t be filled. Consider the performance of General Electric (NYSE:GE) after Jack Welch retired and Microsoft (NASDAQ:MSFT) after Bill Gates began relinquishing his responsibilities. So how do you guard against these situations and disasters similar to what BP (NYSE:BP) and its shareholders are currently facing?
Something Bad Will Happen
Eventually, every investor will hold a stock that falls out of favor and endures a double-digit decline. Understanding this from the onset makes it easier to deal with. If we go ahead and accept this as fact, then when it happens it really shouldn’t be a shock. This sounds simple, but is really an important step in removing emotion from the equation. It is much easier to reach the correct hold or sell decision when evaluating the facts from a rational perspective.
Diversify Your Holdings
When bad things happen to an individual stock, it usually pulls down other stocks in the same industry. Consider the April 20, 2010 explosion and fire on Transocean Ltd’s (NYSE:RIG) drilling rig, which Deepwater Horizon licensed to BP and where 11 workers were killed. It is more than a month later and BP still has not stopped the oil flow. Below you can see that several companies in the same industry, have all under-performed the S&P 500 (NYSEARCA:SPY), some more than others:
|Company||Apr 19||Jun 1||%|
|S&P 500 (SPY)||$119.81||$107.53||-10.2%|
Limit Your Exposure
The single most important thing you can do to manage the risk associated with holding individual stocks is to simply limit your exposure. My standing rule is to limit each individual stock to no more than 5% of my income portfolio, based on market value and income. If any single company were to go bankrupt and the stock went to $0, my loss would be less than 5% – the market has moved my portfolio more than that in a single day.
At the end of March I held a position in BP that represented 1.6% of my income portfolio and generated 2.1% the portfolio’s income. This small position kept me from being overly concerned. If BP ended up bankrupting, these would not have been dramatic losses. Limiting your exposure in any single stock to a reasonable level lets you sleep at night even when that stock is facing adversity.
Focus On Quality
Your core portfolio should focus on quality with the “meat and potatoes” blue-chip stocks. You might want to add some high-yield and high-risk stocks in limited amounts to “spice” things up. Below are several quality blue-chip stocks that are the cornerstone of most dividend growth investors' portfolios, along with their risk number:
Finally, it is a good idea to have a written mission statement for your income portfolio that includes your goals and what you will and will not do in the portfolio. It may sound silly to take the time to write this down, but it is very helpful when fear or greed tempts you from your predefined path.
Full Disclosure: Long JNJ, ABT, MCD, PG, KO. See a list of all my income holdings here.