Do good stocks make a good portfolio?  Not necessarily!

One of the more difficult concepts for investors is that good stock selection is different than good portfolio management.  Just because a good company has a good stock, that does not mean it should be bought.  For example, a good pharmaceutical stock should not be bought in a portfolio that is already too heavily weighted in the pharmaceutical sector, because it reduces diversification — therefore increasing risk.

Another problem is correlation.  Do you really want all your stocks moving the same?  How about some stocks that go up when certain other stocks go down?  That is called negative correlation and is an important part of portfolio construction.

Large institutional investors like pension plans focus more on their overall portfolios instead of their individual stocks.  They call it “Modern Portfolio Theory” – (MPT).

I believe there is much wisdom to MPT but, like all good theories, it can be carried too far.  For example, what percentage of your portfolio should be large companies, small companies, dividend-paying companies, international stocks, real estate, commodities, etc.  There is a technique to determine this called the “efficient frontier,” which can be developed using “optimization” software.  MPT is good, but the efficient frontier is meaningless, as it changes every single day.

Clients should be aware of how their portfolio is allocated between the various asset classes, such as large & small companies, foreign & domestic, equities & fixed income, etc.  If you don’t, call your financial advisor . . . now!