How to Diversify Your Healthcare Investments

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On this week's episode of Industry Focus: Healthcare, analysts Kristine Harjes and Todd Campbell get back to basics and explain what you need to know about diversifying your portfolio, especially when you're investing in a sector as volatile as healthcare is.

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Find out why it's so important to diversify but also not be too diversified, how many different stocks an individual investor should aim for in their portfolio, the most important things you need to look at before buying into an ultra-risky clinical-stage biotech, how you can diversify your investments in the healthcare sector, some tools and metrics you can use today to start measuring your diversification, and more.

A full transcript follows the video.

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This video was recorded on Oct. 25, 2017.

Kristine Harjes: Hi, everyone! Kristine here, just letting you know that the episode you're about to hear was pre-recorded in October. We're playing it for you on November 22nd, just before the Thanksgiving holiday. I'm back in New Jersey with my family, and the rest of the team is also out for the rest of the week as well. So, sadly, there won't be any shows released tomorrow, Thanksgiving, or Friday. We'll be back to normal programming on Monday.

Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Kristine Harjes, and I have in studio with me right now healthcare analyst Todd Campbell. Todd, welcome to Fool HQ!

Todd Campbell: Kristine, thanks so much for inviting me to come down. It's so great to be on the show with you live and in person.

Harjes: This is very exciting. As our regular listeners have probably picked up on, usually Todd is skyping in, but he's here in Alexandria, Virginia today because we're having our annual writers conference, where all of the fool.com writers come in for a couple of days of meeting each other and meeting the in-house gang and doing a bunch of workshops. We're about to kick it off in a few hours, and we're very excited to have you all here.

Campbell: This is such a wonderful opportunity to connect with all the great people that work for The Fool, and fellow writers for healthcare, and to be able to share our experiences and what we think about certain things. I'm sure we're going to get some really great articles out of some of those conversations.

Harjes: Absolutely, and I can't wait to read them. It's always a really great opportunity to talk shop with people. We're all a bunch of investing nerds. Already, this morning, the conference hasn't even started yet, but there have been writers floating through the editorial part of the fifth floor here at HQ, and they'll stop by and be like, "What do you think of Apple?" You, just can't help it, that's what we're ultimately all here to do, is share in this love of investing. Should be a lot of fun. Before we get to all the festivities, we figured we would record an episode, since I so rarely get to do this while looking at you face to face in the studio. It should be a really fun episode.

Campbell: Yeah. I think it's going to be a really important episode, because we're going to talk about some foundational topics, about how to build and structure a portfolio. I think that's really an important and sometimes overlooked part of investing.

Harjes: Yeah. We're going back to basics here. On the show, we talk all the time about our different stocks that are on our watch lists, and things that we own, but we don't really talk a whole lot about how to put that together in the broader scope of your whole portfolio. Some of the topics that we want to hit today, we want to talk about why you should be diversified, why own stocks at all, why own healthcare stocks -- because of course, we have to bring it back to healthcare in the end. Hopefully we can give our listeners some really good takeaways about portfolio management in a higher-level sense. First off, we are a stock-picking company, we talk about buying stocks all the time. But that's not the only place you can invest. You want to give our listeners an idea of some of the other places that you can invest money?

Campbell: Do you mean as far as, diversifying across bonds and commodities?

Harjes: And metals and real estate.

Campbell: Absolutely. I mean, healthcare is the only game in town. What are you talking about, Kristine?

Harjes: [laughs] It's biotech or bust.

Campbell: [laughs] I mean, come on, 100% plus margin. Come on. No, I mean, there are a lot of different places that you can put your money. And it doesn't have to all be in stocks. And for many people, it shouldn't be. Obviously, as we get older and our income streams change, perhaps we're retiring and collecting Social Security or something else, and our income isn't quite as high as it was when we were working full-time, we want to have things like bonds. And if we have some tax issues, maybe we want to be looking in bonds and saying, maybe we want to have some municipal bonds so that we have some tax advantages. Or maybe we want to have some insulation. Some of the leading portfolio managers out there recommend that you have 5% in gold, for example, as an allocation to insulate yourself a little bit of some of the risks of instability in the world. So, yes, there are a lot of different places where people can invest their money outside of individual stocks. They can buy oil futures, they can buy all sorts of crazy things. For most people, once you get beyond equities and bonds, you're talking about taking out a lot more risk in the portfolio, and I think that's something that every investor has to balance. You're not just talking about each individual piece of your portfolio. You're talking about how it all in the end comes together. What's the aggregate effect this is going to have on my pool of cash. So, thinking to yourself, I can put 5% in gold. Well, you only have 5% in gold, but what's that going to mean for the broader portfolio that you have? Is that enough, or is that too much?

Harjes: And something to also consider is how much you should be investing at all, as opposed to holding it in cash. If you're going to need that money relatively soon, within the next three to five years, it's probably not a good idea to tie it up in, particularly, the stock market or more volatile asset classes. So, definitely something to be considering, particularly as you get older. If you're going to need the income in retirement relatively soon, you might not want to invest it at all in any of these asset classes that we're talking about. 

Campbell: Right. And as stock pickers, you make a great point. David and Tom Gardner have talked about this in the past, about having a little bit of dry powder held back to be able to take advantage of opportunities that they see along the way. If you're investing 100% of all your money that you can invest, you're not going to be able to take advantage of some of those blips on the radar.

Harjes: That's a great point, too. With that said, let's talk specifically about stocks. The sector of your broader wealth that you decide should be devoted to stocks, how do you diversify that, and how many stocks must you own in order to feel like you're diversified? What are your thoughts there?

Campbell: There have been a lot of studies that have been done that talk about the right amount of stocks. I'm a stock picker, so most of my money is in individual stocks. What I've discovered is, if you're managing a very large pool of money -- for example, let's say you're a portfolio manager managing billions of dollars, then you're going to want to own 50-plus stocks. You almost have to, just because you have so much money under management, and if you try to own a small number of stocks, you would own 20% of each one of the float of those stocks. You just couldn't conceivably do it. For individual investors, I think the sweet spot tends to come down to that 15-20. You get much beyond that, and I think there's been research that's been done that says that, as humans, we can only handle so many things at once. And I think once you get beyond into those double digits, your ability to handle those things really starts to fall off. So, if you have a portfolio of 50 in your stocks, and you're trying to manage that yourself as an individual, plus work full time, you're probably going to miss some things along the way.

Harjes: Yeah, it's putting a lot of work on yourself to keep up with every single one of those 50 different companies. There are also going to be a ton of transaction fees associated with buying and maintaining reasonable amounts of all of these different stocks that are going on. I'll also add that if you have too many stocks, you're probably just going to revert to the mean. What I mean by that is, if you're so diversified that you own 200 different stocks, you might as well just own some sort of S&P tracking Index Fund, and you'll basically get the same in return without the hassle of having to keep up with all those companies and considering yourself a part business owner, because that's what you are as a shareholder, and you won't have the transaction fees of having to buy them each individually. I also will point out that too few stocks is also a problem. You don't want to have under that 15 for amount, just because a single failure at that point -- if you only own, say, five stocks, and one of them goes completely under, you're losing out on a very sizable amount of your wealth. Particularly if you have a lot of your total net worth in stocks, that can be really devastating. That sort of risk will absolutely keep you up at night.

Campbell: Keep you up at night, and potentially cause some very big long-term damage to your portfolio value. We see this in healthcare all the time, when we're talking about biotechnology. It's boom or bust. If you have a clinical-stage biotech, and you own three of them in your portfolio and that's all you own, one goes south on you and you've just taken a huge, huge hit. But you also see that in other sectors and industries as well. Oil and gas has had its fair share of companies that have ended up in bankruptcy as well. Technology, some of the smaller technology companies, they flame out relatively quickly. So, I think that while the temptation is to try and strike it rich with a big swing, you have to remember that oftentimes, when you swing, you also miss.

Harjes: Yeah, absolutely. Before we move on, I wanted to do a quick plug for some of The Motley Fool's other podcasts. Even though we love Industry Focus here on Industry Focus, The Motley Fool actually has five total podcasts. If you haven't checked them out before, you can head to podcasts.fool.com to see the entire collection, including the weekly Rule Breaker Investing podcast, which is excellent and hosted by Motley Fool co-founder David Gardner himself. Very cool, head to podcasts.fool.com to see more.

I think something that's important to recognize is, there are two widely established categories of risk that we're dealing with here. There's something called systematic risk, that's also known as market risk. That's something that's an event that could affect the entire market. So, this is why you diversify across different asset classes. Say the stock market crashes -- that's an example of systematic risk, where every single one of your stocks is likely to plummet because of that. But you also have something called idiosyncratic risk, and this is also called specific risk. This is something that is specific to a single industry or even a single asset. We were talking about boom or bust biotechs, so, that would be something like, your drug fails in a clinical trial, so that's going to really hamper the stock. And depending on how much of the company's value is tied to that single drug, you could be erasing 90% of the market cap, something like what we saw Ophthotech, where their main and only drug completely flopped, and it wiped out almost all of the market cap of this company. However, there's also idiosyncratic risk that's specific to an industry as a whole. This could be something like, if there was some sort of drug price reform, and all of the sudden all drug makers are required to have a cap on their margins, or something crazy like that. Political is an obvious example of this, the political risk that could happen to an entire industry. But, you could also get things like consumer spending, for example, that could hit retail as an entire sector really hard if all of the sudden unemployment goes up, and people don't have as much discretionary income anymore. The different types of risk are important to understand because it makes you think about how you're not just diversified because you own 15 to 25 stocks. You also need to figure out, how highly correlated are those stocks, and are you attacking different strategies with them? Are you hitting different geographies? Are they made up of different market caps?

Campbell: Right, which, obviously brings you to the idea of, should I own international stocks as well? There are a lot of ways to make sure you're not too correlated. Usually, when you talk about correlation, you're comparing it to the benchmark, so, we'll say the S&P 500. You can run correlation pretty easy using Excel spreadsheets, and calculate those things out on your own. Which, of course, it's much easier to do if you have a portfolio that's only 12 to 15 names. And you can see just how much risk you're taking on. You can also, just by going to Yahoo finance or some of these other sites, you can check the beta, which shows you how much the stock will move when the S&P also moves up or down. So, you can find that, if I have a lot of beta in my portfolio -- so, let's say I have a beta of 2, that means it's going to move 2X how the S&P moves.

Harjes: On average.

Campbell: On average. So, I'm exposed to a significant amount of risk if the market tumbles, or whatever. Then, you can also do correlation for the individual industries in healthcare, and say, "Are my biotech stocks too heavily correlated to my drug makers, my medical equipment stocks, my medical instrument stocks, how the insurer stocks fit in vs. biotech, etc. So, considering beta, considering correlation, those are ways that you can make sure that all of your eggs aren't in the same basket.

Harjes: You mention that healthcare is a fairly diverse field to begin with. That gives me a little segue to be able to admit something to you, which is that I am personally grossly overweight in healthcare. And that's because I get really excited about it. I love the industry. But, the way I can justify this is, healthcare itself is a fairly diverse sector. You have different types of healthcare stocks. For example, you have small caps, you have large caps, you have mid-caps. That's, of course, the market cap of the company. In general, if you have a big established Goliath like a Johnson & Johnson (NYSE: JNJ), that in and of itself is a fairly diversified stock. They have all these different units within the company, they have an international business. As opposed to something like, I mentioned earlier, Ophthotech. I was a shareholder of Ophthotech. That was a very small-cap company that had a single point of failure. It obviously didn't go well. So, you have, within the industry itself, different market caps, you have different geographies. We talked on the show about Teva, for example, they're an Israeli company. They do a lot of business all over the world. But it's certainly possible to have shares of companies like, say, AstraZeneca or GlaxoSmithKline.

Campbell: Roche.

Harjes: Yeah. Lots of drug makers are headquartered overseas. You also have non-drug maker healthcare stocks. Every once in a while, we'll get a listener write in in like, "Why don't you talk about any other areas of healthcare except for drug makers?" And the answer to that is just that it's the most exciting part of healthcare. At least, Todd, I think you'll agree with me there, there's always news about what drugs are getting approved and how trials are going. But there are other parts to healthcare. Hopefully we touch on them enough to keep you guys informed. You have your insurers and your retail pharmacies, your PBMs.

Campbell: Technology companies.

Harjes: Yeah, like Veeva. All this is to say, within a single sector, you can actually get pretty diversified. As important as it is to touch on different sectors, it's possible to be diversified within each one, and it's actually important to be diversified within each one, because you can fool yourself into thinking you're diversified because you have two financial stocks and two healthcare stocks and two consumer discretionary stocks. But if all of those are, say, micro-caps, then you're really not that diversified.

Campbell: You raised so many cool points there. One of the things that resonated with me, or jumped out to me, was Peter Lynch. Famous money manager for Fidelity for years. Wrote a wonderful book, Beating the Street. And he always advocated buying what you know. Invest in what you know. Well, the risk that you run when you invest in what you know, and we talk healthcare all the time, is that you get very heavily concentrated within that particular area that you know a lot about. If you work in retail, you end up owning a portfolio that's 80% in retail. If you work in healthcare, you own a portfolio that's 80% healthcare. There can be advantages to that, i.e., if you know the industry and they players really well, maybe that enhances your ability to pick the correct stock. Also, that concentration will allow you to outperform the S&P 500 Index during periods where the stocks that you own work.

Harjes: Yeah, when you're right.

Campbell: When you're right. You also brought up the point of being diversified within each individual sector. You're talking about healthcare, you look at your healthcare holdings. Owning an insurer and owning a big-cap pharmaceutical company and owning, let's face it, I happen to take on some risk in my portfolio, so sometimes I tend to own some small cap clinical-stage companies. And these companies are make it or break it companies. And as we already outlined, if their trials go wrong or they receive a rejection letter from the FDA, you could lose 80% of the value in a particular stock. So, I always spread it around a little bit. Just to throw out numbers, let's say I have $3,000 that I can do something with and I have three clinical-stage companies that I've done my homework on, I feel pretty good about, and I'm going to lean the odds in favor of victory for these companies. Maybe leaning the odds is 60-40 or something like that. Again, there's no such thing as a sure thing. So, you say to yourself, I'll take that $3,000 and divide it between those three companies. Now, one may fall 80%, like Axovant Sciences or something recently with its Alzheimer's disease failure. But the other, Zogenix, may have a success in their epilepsy trial and triple. If you look at them as a whole, you ended up making money. So, I think the big thing to remember there is, keep everything in perspective relative to the portfolio and the risk that you're willing to take, obviously. Maybe that $3,000 is in a portfolio of $100,000, or something like that. If you lose $1,000 on a particular stock, it's really not going to move the needle that much for you. But, yeah, there's a lot of different ways that you can help insulate yourself against risk, and that always brings me to the thought of, how much do I really want to have in healthcare? In my portfolio, maybe I'm not as overweight as potentially you are, I have about 25% of my portfolio in healthcare stocks, but that is overweight relative to the S&P 500, which is, what?

Harjes: 14.5%.

Campbell: 14.5%. And, overweighted as a percentage of GDP, because I think as a percent of GDP, healthcare spending is about 17.8%. So, there are different ways that you can look at, how much do I want to have exposure to. If I'm running a diversified portfolio of individual investments, how diversified do I want to be? Maybe you want to tie it to the GDP spending number. There are a lot of reasons that healthcare makes sense to have in your portfolio. We talk about them all the time on the show. 10,000 baby boomers turning 65 every day. You have $8 trillion being spent globally on healthcare, and some estimates peg that number going to $18 trillion over the course of the next 15 to 20 years. This is a growth market, it's an interesting market, it's a fascinating market, it deserves a spot in portfolios. Don't be too afraid of going a little bit over what may seem prudent, in that 14-15% S&P range.

Harjes: Another thing to point out about the healthcare industry is that these are necessary expenses. People are going to be paying insurance premiums and buying prescription drugs. These are not consumer discretionary purchases. They are medications that are life-saving, that people are going to be buying year-in and year-out regardless of what the rest of the economy is doing.

Campbell: And with big pharma, we've talked about this on the show with Johnson & Johnson, historically -- past performance doesn't guarantee future performance -- companies like Johnson & Johnson tend to do better during periods of stock market pullbacks because of that. And, you get the dividends.

Harjes: Yeah. Johnson & Johnson is a fantastic example of a company that has minimal downside risk when the rest of the market seems to be tanking. They've been able to weather the storm very well, and continue paying that dividend for over 50 years. It's really an incredible, I'm picturing a giant stable ship going through a bunch of storms. That's Johnson & Johnson for you.

Campbell: Right. And having that as a core holding in your portfolio, and then being able to have some fun with some of these clinical-stages, that's probably a lot wiser of a choice than trying to go out and saying, "I'm going all in MediGene!" [laughs] 

Harjes: Yeah, bet the ranch because you heard a stock tip on Industry Focus. So, hopefully that gives our listeners some sort of better sense of how the two of us, at least, approach portfolio management, and putting together a basket of stocks that helps us sleep at night, but ultimately can help us outperform the market. If we didn't want to take on any risk at all, we could just track the market itself. But our goal here at The Motley Fool is, over the long-term, beat the market. Before we sign off, Todd, any final words of wisdom for our listeners? I know you hate when I put you on the spot like that. [laughs] 

Campbell: [laughs] You do that, and I had a fun time with Dylan on the Technology show.

Harjes: Oh, I heard.

Campbell: And I'm fessing up, that, yes, Kristine, I went on another podcast. But, I always say, diversify, diversify, diversify. And I do that for a reason. Please, listeners, recognize that there are a lot of risks out there. This is a long game. Play the long game. Don't play the short game. Go out there, make wise choices. Do your research. Do your homework. Don't be afraid of going out and buying individual stocks, but recognize that you're not going to be right a lot.

Harjes: But the most you can lose is everything, which -- [laughs] that sounds terrible, putting it that way. But, what I mean by that is, if you're right half the time, your winners are going too far, far outweigh your losers, because you can make double, triple, quadruple, 10X your investment, as opposed to, the most that you can lose, as long as you're doing normal investing and you're not dabbling in options or any of this other business -- which is not to say that you shouldn't try that -- but, if you're just doing regular, run-of-the-mill investing, the most you can lose is whatever it was that you risked to begin with.

Campbell: Yeah. Think about it like baseball. If you're batting 300, you're a very good hitter. And in the stock market, if you're getting one nice, big win one out of three buys, you're doing fine. You're doing great.

Harjes: You're doing great. Alright. Thanks so much, Todd. I'm very much looking forward to continuing the conversation some more once we kick off the conference in a couple of hours. Thanks for being here today!

Campbell: Thank you for having me! It was fun!

Harjes: As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes owns shares of Apple and Johnson & Johnson. Todd Campbell owns shares of Apple. The Motley Fool owns shares of and recommends Apple, Johnson & Johnson, and Veeva Systems. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.