Portfolio diversity

Robinhood Portfolio Diversity: An Introduction to Portfolio Diversification

Disclaimer: Lean Investments is a financial education and entertainment website. None of the content below should be misconstrued as investment advice or a recommendation. The author holds none of the positions mentioned below.

When you buy a stock on the Robinhood app, you will be presented with various information on your new position. This includes the number of shares in the stock you own, the value or “equity” of your position, the average cost of your shares (also know as the cost basis), today’s return (how much you gained or lost today) and your overall return, how much you have gained or lost since you bought the stock.

Finally, you’ll also see something called “portfolio diversity,” or how much of your overall portfolio in Robinhood is represented by your position in the stock.

This article will focus on how you can use the Robinhood portfolio diversity information and present different perspectives on the broader concept of portfolio diversification.

Portfolio Diversity and Single Stock Risk

The Robinhood portfolio diversity feature allows users to see at a glance how concentrated any individual stock position is in their overall portfolio. This is useful for a few different reasons including understanding how much of your portfolio could be impacted if one of your stock positions takes a nosedive.

Any stock can fall and fall hard for any number of reasons. Just in the past year we have seen dramatic falls in popular stocks held by Robinhood users. Reasons a stock can fall can include outright fraud, missed earnings estimates, an abrupt change in corporate leadership or simply a slowing of growth. And these issues can happen even during a strong bull market for stocks overall.

Here are some examples of painful individual stock declines, just since 2020:

Luckin’ Coffee (LKNCY) dropped more than 90% in a matter of two months after a major fraud was revealed showing management intentionally inflated revenues. The stock was eventually delisted from the NASDAQ and now trades in the OTC markets.

Nikola (NKLA) has lost more than half its value in the past 12 months and is more than 70% down from its high after a short-seller report questioned the company’s claims about its products and the company’s CEO stepped down amid the controversy.

Tencent Music (TME) was once billed as the Spotify of China, but has since been caught up in a regulatory crackdown in its home market, losing its exclusivity rights to much of its music catalogue in the process. The stock was also caught up in a hedge fund blow up early in 2021 showing the multiple causes a single stock can blow up in an investor’s face in a short amount of time. The result is that the stock has dropped more than 60% in just the past 6 months.

Boston Beer Co. (SAM) shows that even highly regarded stocks with popular products can take a nosedive with very limited notice. The beer maker had been on a tear with the growth of its Truly Hard Seltzer line. Unfortunately, management failed to forecast that the economy reopening would alter consumers’ buying behaviors and take them to bars where the Seltzer product was less established. The jarring slowdown in growth, coupled with a stumble in management’s failing to warn investors ahead of time resulted in a 25% drop in the stock’s price in a single day in July 2021.

We hope the examples above illuminate some of the potential pitfalls of holding single stocks and especially holding only a few of them in a concentrated portfolio. If you were only holding three stocks in your portfolio in equal weight and experienced an event such as the above, it could devastate your entire account balance.

It would be very difficult for the average Robinhood investor to anticipate ahead of time Boston Beer’s poor sales forecast, or to understand the extent of China’s regulatory crackdown that has negatively impacted hundreds of the country’s tech, education and entertainment stocks. In the cases of Nikola and Luckin’ Coffee, fraudulent activity was revealed over the course of months long investigations by dedicated short-seller research firms with vast resources and extensive experience to carry out their investigations.

This is ultimately why Robinhood’s portfolio diversity feature is a useful gut check; when you enter a new stock position and are presented with the percentage of your account that the stock now occupies, you can better visualize the impact to your portfolio should the stock experience a negative event like above or even a worse case scenario of the stock going to zero.

The Benefits of a Diversified Portfolio

Portfolio diversity as displayed on the Robinhood app is just a starting point in understanding portfolio diversification. While portfolio diversity can you help identify when any single stock takes up a disproportionately large position in your portfolio, mitigating single stock risk is only one factor in having a truly diversified portfolio.

The details of diversification can become complex and are outside the scope of this article but we will summarize some of the most important additional considerations for diversification and link to helpful resources below.

Investors holding their positions for the long-term need to be cognizant of additional risks to their portfolio that diversification can help mitigate. Some (but not all) are listed below:

  • Single stock risk – As discussed above any single stock can fail for a host of reasons. You ant to be diversified across many stocks to help mitigate the risk of one failing and hurting your portfolio.
  • Sector risk – A big lesson in early 2021 for many Robinhood and Reddit investors is that you can be too concentrated in a single sector or style. After a stellar 2020, high-tech and speculative growth stocks stumbled as the economy began to reopen and value stocks surged. Many investors who bought in to the growth names at the highs ended up experiencing significant losses of 20% or more. Not only that, by failing to diversify across sectors they missed out on the rebound experienced by cyclical and value stocks.
  • Geographic risk – As we’ve seen with the Tencent Music and Luckin’ Coffee examples above, each country carries its own risks and potential benefits. Chinese stocks carry great growth potential but also must satisfy the Chinese government’s regulations, which can change on a dime. Getting carried away with having too many stocks in any one foreign market can leave you open to a host of risks related to that country’s currency, government policies and overall health of its economy. On the flip side, allocating 100% to US stocks means you will miss out on times when foreign markets rally.
  • Asset class risk – Stocks as a group carry a host of risks. You could have invested in stock index funds in 2000 or 2008 and still have losses of 40% or more because when the economy takes a nosedive, the stock market usually follows. This is why many investors seek to diversify at least part of their portfolio with bonds, precious metals, commodities and cryptocurrency.

To learn more about portfolio diversification from quality sources, check out the following links below:

Robinhood Investors Lack Diversification

Based on various studies reported in the media it seems Robinhood investors as a whole are not particularly diversified. It’s also somewhat difficult to know how concerning this should be. Many Robinhood investors will have a 401k or other retirement account from their work that is likely invested in diversified funds. Some will even have additional brokerage accounts at other brokers such as Fidelity, Interactive Brokers or TD Ameritrade.

There also must be a significant portion of users who received a free gift stock from a friend and then fail to add any additional funds or positions to their portfolio and may even forget they have a Robinhood account.

There is also the group of investors that Lean Investments seeks to engage, those building a portfolio with limited resources, perhaps sending just a few dollars every other week into their Robinhood account in the hopes of slowly growing their account balance overtime. If this is you, check out the following section on our ideas of how to achieve some diversification in your portfolio, even with a low balance.

Beyond these groups, it seems clear there is some portion of Robinhood investors that have a gambling instinct and may have a large portion of their overall portfolio in speculative growth stocks, bitcoin or even leveraged options. While 2020 was a historically great year for many investments, it may also contribute to a sense among this group that making concentrated bets and throwing diversification to the wind is a successful strategy. Market history tends to show that such tactics rarely work over the long-term and most investors, especially novices, should embrace diversification as “the only free lunch in investing,” according to Nobel Prize winner Harry Markowitz.

Even before 2020, a study from The Next Web (via Robintrack data) concluded:

Robinhood currently has approximately 6 million users. According to Robintrack’s data, there exist just over 12 million unique holdings, meaning that the average Robinhood user owns stocks in two different publicly listed companies or ETFs.

Just looking at the average amount of unique ownerships per user, the standard Robinhood user doesn’t look very diversified.

DATA: Robinhood users are really bad at portfolio diversification

Diversification Ideas for Small Accounts

Of course it’s much easier to have a truly diversified portfolio with a large account that can comfortably invest in many different diversified funds across different asset classes.

However, thanks to some innovations driven by Robinhood and the broader financial industry, it has never been easier to gain diversification in a small account.

  • Index ETFs – This is the most obvious way to gain diversification. A stock index exchange traded fund (ETF) gives you access to hundreds of stocks, such as the S&P 500, a collection of very large, global companies. An additional benefit of an index fund is the ability to invest in a number of world-class companies without having to pony up the cost of the individual shares themselves. This means you can invest in Amazon without forking over the $3,500 + dollars one share of that company costs.
  • Fractional shares – A more precise method is to buy fractional shares, a relatively new development offered by Robinhood that lets you buy a dollar amount of the stock you want, rather than a full share. Again, using Amazon as an example, this means you could buy $50 worth of the stock instead of the full share which currently trades at more than $3,500. This is also a great way to avoid only buying low priced stocks and penny stocks on a low balance. Fractional share trading allows you to access even the most expensive companies with a low account size.
  • Mix growth and value – Another approach is to simply alternate your stock buying between higher growth names (e.g. Tesla) with more staid, value picks (such as GE). This may provide partial protection to your portfolio when market sentiment swings between the two as it has done throughout 2021.
  • Mix blue chips with small caps – Robinhood investors tend to overweight small caps and even penny stocks according to data from The Next Web. This is partly because new investors tend to have small account balances and want to buy a stock that seems “cheap” to them, not understand the difference between a cheap stock and a low-priced one. To counteract this effect, you can either explore index investing or fractional share buying as above, or commit to investing in blue chip stocks to balance out your small cap names. Blue chip stocks historically are more stable than small and micro cap stocks.
  • Aim for no more than 5% in any one stock – Finally, while it may be impossible at first, aim to limit any position size to no more than 5% of your portfolio. This makes even terrible losses on an individual stock manageable. According to Exploit Investing, a 5% position size is where your unsystematic risk becomes “negligible.”

As you can see, the Robinhood portfolio diversity feature is one small step in understanding the much larger concept of portfolio diversification. If you fee overwhelmed by this information just remember the maxim of “not putting all your eggs in one basket” and try to make diversification progress with your positions over time.