Risk-Free Investments Don’t Exist: The Key to Building a Healthy Portfolio

Investors know the adage that diversification is crucial to maintaining a healthy portfolio. But did you know it may also be critical to your health?

A sudden and significant loss of wealth after age 50 can result in serious health issues and increase the risk of premature death by 50%, according to a recent scientific study. Such “negative wealth shocks” are defined as the loss of 75% of one’s net worth over two years.

Researchers believe that divorce, serious illness, and death of a spouse are the leading causes of negative wealth shock.

In my opinion, failure to diversify a portfolio should be added to that list as a risk factor, just as smoking puts you at risk of lung disease. And, just as chain-smoking is riskier than puffing three butts a week, the more your portfolio relies on one stock, the higher the risk of catastrophic loss.

But it can be hard to quit, whether we’re talking about cigarettes or a well-performing equity.

Let me share the story of one guy who is hooked on a good stock.

Rob was a recent caller to my radio show. In 2012, Rob (not his real name) inherited $250,000 worth of Sherwin Williams (SHW) stock, then valued at $100 per share. Now those shares are at $400-plus, making his holdings worth over $1.0 million – the lion’s share of his portfolio.

Rob is savvy enough to be nervous. Sherwin Williams has done well over the last five or so years, but he wanted an assessment of the risk this imbalance poses to his portfolio, a sense of SHW’s near-term prospects and advice on the tax implications of selling part of his SHW stake.

Whew! Let’s take it from the top.

What do no-risk stocks have in common with unicorns and leprechauns? That’s right; they don’t exist. Even the oldest, biggest, most venerable companies can dip, tumble, even crash and burn. Take for example the stalwart stock of GE. In September of 2000, GE was at an all-time high. But, for a variety of reasons, the company hit the skids and is currently down 77% from that 2000 heyday.

GE is a great example of a company that’s still around, that’s still in the DOW but has dropped dramatically in value. Our lesson here is that a company doesn’t have to go out of business to lose tremendous value – in this case, 75%. Of course, this data doesn’t count dividends people received along the way, but a dividend is little consolation when your value is down nearly 80%.

And, of course, established, once-high-flying companies do go out of business. Toys-R-Us and Blockbuster were once fixtures on the exchanges and in our lives. No more. Innumerable tech companies were swept under after years of success and solid share prices.

As for Sherwin Williams, it has indeed been a phenomenal stock of late, and it might be an OK stock going forward. SHW appears to be a somewhat cyclical stock, with its value tied very closely to the ups and downs of the housing market. Makes sense, right? New houses need to be painted.

SHW took a beating during the financial crisis and housing collapse, with its share price falling 36% from early 2007 to early 2009. (This wasn’t as bad as the S&P 500’s loss, but still ugly.)

As housing started to come back, Sherwin Williams rallied. It’s up 682% since the recovery began. You won’t be surprised to learn that Home Depot has a similar story.

SHW investors should be happy with the current housing market. We need to add about 1 million houses per year to achieve equilibrium in the market. We’re getting close, but we’re not there yet. Demand is still outpacing supply as evidenced by all those real estate agent ads screaming, “We want your house!!”

Given all of the above, I recommended that Rob begin diversifying away from Sherwin Williams. I would probably start by selling the basis – one-quarter of the SHW shares – and reinvest the proceeds across other sectors.

Based on the household income information Rob shared with me, these long-term gains would be taxed at 29.8%. That will sting, for sure. But, in my opinion, that pain should not stop him from diversifying. If the tax hit is more than he can bear, Rob might consider selling 10% of his SHW share this year and 10% each year going forward until he reaches his diversification target.

This will result in a healthy portfolio and a healthier Rob. When he goes for his next check-up, Rob will be able to tell the doctor, “I’m exercising, cutting back on fat, and I’m diversifying my portfolio.”

Check Out: What To Do When You Miss A Skyrocketing Stock

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