Investing only in stocks can be appealing because stocks often stand out for their growth potential. But like choosing an eye-catching shirt at the mall, the first option that grabs your attention is not always the only piece you need.
Imagine you’re shopping for a new shirt. As you pass a recently opened store, a bright pattern on the mannequin catches your eye. It feels like exactly what you were looking for. But once you see it up close, you start thinking about how it fits with the rest of your closet and whether it works for more than one occasion.
Then you notice a second shirt hanging nearby. It is more muted. and less attention-grabbing, but it could be easier to wear day to day. After weighing your options, you decide both shirts may serve a purpose.
“Shopping” for investments can feel a lot like this. Stocks may be the bold, eye-catching option, but that does not mean they should be the only piece in your portfolio. For many investors, the question is not whether stocks belong in a portfolio, but how they fit with other investments, goals, time horizons, and risk tolerance.
Why Stocks Often Catch Investors’ Attention
Stocks are like the bright, bold shirt that is displayed at the front of the store. They stand out, feel exciting, and make a big impression. For investors, stocks may offer several benefits that make them appealing.
Higher Growth Potential
Compared with assets like bonds or savings accounts, stocks have historically offered higher long-term growth potential. That growth potential is one reason many investors include stocks in their portfolios.
Purchasing Power Over Time
Inflation reduces purchasing power by increasing the cost of goods and services over time. Stocks may help investors keep pace with inflation over the long run. According to Edward Jones, stocks offer “growth of principal and rising income. Stocks that increase their dividends give you a pay raise to help balance the higher costs of living.”
Dividend income
Dividends are a portion of a company’s profits or earnings that may be distributed to shareholders. These payments can be used as additional income, or people may choose to reinvest their dividends to purchase additional shares of the company.
Liquidity
Liquidity is the ease of converting an asset into cash. Publicly traded stocks are typically highly liquid, meaning that they are generally easy to buy and sell.
What Are the Risks of Investing Only in Stocks?
At the same time, like the shirt that looked great but felt different up close, stocks don’t always perform as expected. Stocks can be volatile and unpredictable, and prices can fluctuate quickly based on company performance, economic conditions, investor sentiment, interest rates, and other factors.
Company-Specific Risk
Individual companies can also face risks that are difficult for investors to predict. Even well-managed companies can be affected by changes in government policy, competition, employee fraud, changing consumer preferences, technology shifts, or other events outside of managers’ control.
A January 2023 study by J.P. Morgan Asset Management found that from 1980 to 2020, 42% of companies in the Russell 3000 experienced an absolute negative return over the period studied. In other words, owning individual stocks can create meaningful risk if too much of a portfolio depends on one company or a small number of companies.
Example: Sears and the Risk of Relying on One Company
Sears offers a familiar example of how a once-dominant company can decline. Before Amazon became a major force in retail, Sears was one of the most recognizable retailers in the United States, with a 132-year history. According to Fortune, Sears’ annual revenue in the late 1970s and early 1980s would have equaled nearly 1% of the U.S. gross domestic product, underscoring how significant the company was.
At its peak, Sears was a household name. But as consumer preferences shifted, online retailers grew, and the retail landscape changed. Sears struggled to keep pace. Sears Holdings eventually filed for Chapter 11 bankruptcy on October 15th, 2018.
The lesson is not that investors should avoid stocks altogether. Rather, individual stocks can carry risks that may be difficult to see in advance, which is why portfolio construction matters.
Should Stocks Be Part of Your Portfolio?
For many investors, the answer is yes – but as part of a broader plan.
Though stocks have drawbacks, they can still play an important role in a portfolio. Before investing heavily in stocks, it can help to consider three factors: your risk tolerance, investment horizon, and overall investment strategy.
Risk Tolerance: How Much Volatility Can You Handle?
Do you lean more toward basic wear? Are you comfortable with something bolder? Or a mix of both?
As Investopedia explains, risk tolerance refers to how comfortable you are with the possibility of losing money in the short term in pursuit of higher long-term returns. Investors with higher risk tolerance may be more comfortable holding a larger stock allocation, while investors with lower risk tolerance may prefer a more conservative mix of investments.
Investment Horizon: When Will You Need the Money?
Is the outfit something that you need soon, or are you planning for the future?
Investment horizon refers to how long you expect to keep money invested before you need to use it. According to Investopedia, investors with longer time horizons may be able to take on more risk because they have more time to recover from market pullbacks. By comparison, investors with shorter time horizons may prefer a more conservative approach.
Investment Strategy: Are You Buying and Holding or Trying to Time the Market?
Is this outfit for one event only or is it something you plan to keep wearing over time?
Some investors try to time the market by buying and selling frequently. However, according to U.S. Bank, this approach adds the challenge of timing and increases the risk of being in or out of investments at the wrong time. A buy-and-hold strategy focuses on staying invested for a longer period, even when markets fluctuate, which may help investors stay aligned with long-term goals.
Why Diversification Matters
Perhaps you don’t buy just the bright shirt. Instead, you add a necklace, a jacket, or a pair of shoes to elevate your outfit. You are not relying on one single item. Rather, you build a look using multiple pieces of clothing that work together. In investing terms, this practice is called diversification.
What is Diversification?
Fidelity defines diversification as “the practice of spreading your investments around so that your exposure to any one type of asset is limited.” By doing so, you can help manage the impact of volatility of your portfolio over time.
If you only have bold, patterned shirts, you may struggle to find an outfit for every occasion. However, having a combination of statement pieces and everyday basics gives you more options and flexibility.
Diversification works in a similar way. Rather than investing entirely in stocks, investors can spread their money across different types of assets, such as stocks, bonds, and other securities. In doing so, if one investment doesn’t perform well, others may help to offset the impact.
How Diversification Can Help Manage Risk
After you’ve considered your risk tolerance, investment horizon, and strategy, diversification can help you build a portfolio that aligns with your goals, balancing risk and reward in a way that works best for you.
But how do you do that? Do you need to go out and pick stocks and bonds on your own? Carefully selecting each investment like you’re sorting through dozens of clothes at the stores?
Not necessarily. One way investors may add diversification without selecting every individual investment themselves is through mutual funds.
How Mutual Funds Can Help Investors Diversify
Instead of browsing for individual pieces of clothing, imagine finding a store with ready-made outfits. Each outfit is carefully designed with a mix of clothing that works well together based on specific style or purpose.
In the investing world, mutual funds can serve a similar role. They are one way investors may add diversification without selecting every individual investment on their own.
What is a Mutual Fund?
A mutual fund is an investment product that pools money from many investors. The funds are then used to purchase a collection of securities, which may consist of a variety of stocks, bonds, short-term instruments, or a combination of investment products.
How Mutual Funds Support Diversification
Mutual funds help with diversifying your portfolio in several ways.
- You can build a more complete wardrobe (diversification): As previously mentioned, mutual funds may be a combination of many securities, including stocks and bonds. By pooling money from many investors, you can have a more diversified portfolio compared to buying individual securities on your own.
- You can have a stylist (professional management): Many mutual funds are actively managed, which means a professional portfolio manager decides to buy or sell securities, actively monitoring the securities within the portfolio and making decisions based on risk, price fluctuations, or economic changes.
- You can sell your outfits easily (liquidity): Mutual funds are normally very liquid, meaning shares can be redeemed on any business day.
Types of Mutual Funds Investors May Encounter
Mutual funds are one way investors may add diversification without selecting every individual investment on their own. Mutual funds can be built around different objectives, asset classes, and investment styles. Common types include:
- Index Funds: These funds aim to track a market index, like the S&P 500, by investing in the same assets and weights as the target index.
- Equity Funds: Equity Funds invest primarily in U.S. and/or foreign stocks. They may invest in larger, more established companies or smaller, newer companies.
- Fixed Income Funds: Fixed Income Funds invest primarily in bonds or other income-producing securities such as corporate bonds, government bonds, or municipal bonds. Municipal bond funds may offer income that is exempt from federal income tax, depending on the fund and the investor’s situation.
- Money Market Funds: Most of the time, these lower-risk investment funds will invest in cash equivalents like CDs and Treasury bills.
- Asset Allocation Funds: These funds consist of specific amounts of fixed income and equity holdings. The fund’s goal determines how the investments are allocated between the holdings.
The Bottom Line: Building a Portfolio That Works Together
Investing is like shopping for clothes.
Some products, like individual stocks, can stand out more. They are the bold, eye-catching pieces of clothing, but they may not always work for every occasion, and it may be hard to put a full outfit together.
Other tools, like mutual funds, can help bring your outfit together. They offer diversification, which helps you build a portfolio that works rather than relying on a single investment.
However, just like putting together the perfect outfit, there is no one-size-fits-all approach. What may work for one person may not work for another. Before you build your outfit and portfolio, it’s vital to understand your goals, timeline, and your comfort taking risks. This will help you choose the investments that make the most sense for your situation.
Whether you are building an outfit or planning for your financial future, success isn’t about picking one thing, it’s about how everything works together.
Sources:
Investing Basics: The Benefits of Mutual Funds | Investment Company Institute
125 years later, Sears looks a lot different. Here’s what happened
The Rise and Fall of Sears: A Timeline From Its Founding to Its Bankruptcy
JP Morgan – Managing Concentrated Positions Overview
What Is Risk Tolerance, and Why Does It Matter?
Investment Horizon: Considerations For Your Portfolio
Why Buy-and-Hold Stocks for Long-Term Investing | U.S. Bank
Invest Wisely: Understanding the Benefits of Stock Investing | Edward Jones
