One of the most important concepts in portfolio management is understanding how a single underperforming or losing stock can negatively affect the performance of an entire investment portfolio.

Investors often focus on the number of stocks that are performing well compared with those that are performing poorly. However, the overall performance of a portfolio does not depend simply on how many investments generate positive or negative returns. It depends on the size of each investment, its contribution to total returns, the magnitude of its losses and its impact on the portfolio’s risk profile.

A portfolio may contain 10, 20 or even 50 stocks, and most of them may be delivering positive returns. Yet, one stock experiencing a significant decline can offset the gains generated by several other investments.

This happens particularly when a portfolio has a large allocation to one company, when that company’s share price falls significantly, or when the stock continues to underperform over an extended period.

The impact of one losing stock on overall portfolio returns

Every stock in a portfolio contributes to the overall investment return based on the percentage of capital allocated to it.

For example, consider an investor who has a portfolio worth $100,000 invested across five different stocks.

In this example, four out of five stocks are performing positively. However, Stock E has experienced a 50% decline.

The other four stocks have collectively generated $9,350 in profits, but Stock E has lost $5,000.

As a result, the portfolio generates only $4,350 in total profit.

This example demonstrates that even when most investments are performing well, one significantly underperforming stock can reduce the overall portfolio return.

If Stock E had not experienced the loss, the portfolio would have generated a return of 9.35%.

Therefore, one losing stock has reduced the portfolio’s return by five percentage points.

Concentration risk: Why a heavily weighted losing stock is dangerous

One of the biggest reasons a losing stock can affect portfolio performance is concentration risk.

Concentration risk occurs when a significant proportion of the portfolio’s total capital is invested in a single company, industry or asset.

The larger the allocation to a particular stock, the greater its influence on the overall portfolio performance.

For example, imagine two investors:

• Investor A allocates 5% of their portfolio to a particular stock.
• Investor B allocates 30% of their portfolio to the same stock.

If that stock loses 50% of its value, the impact will be very different.

This clearly shows that a stock with a large portfolio allocation can create substantial performance problems even if the rest of the portfolio is relatively stable.

For example, if an investor has 30% of their capital invested in one company and that company loses 50%, the entire portfolio immediately suffers a 15% loss, assuming all other investments remain unchanged.

This is why portfolio managers closely monitor individual stock weights and avoid allowing one investment to dominate the overall portfolio without a deliberate reason.

Losses create an asymmetrical recovery challenge

One of the most overlooked consequences of holding a losing stock is that the percentage gain required to recover a loss is greater than the percentage originally lost.

This is because losses are calculated on a declining capital base.

For example:

Consider a stock purchased at $100.

If its price declines to $50, the investor has lost 50% of the original investment.

To return to $100, the stock must now increase by 100%.

This creates a substantial challenge for portfolio performance.

Even if the stock eventually recovers, the time required to regain its previous value can negatively affect the portfolio’s cumulative returns.

Furthermore, capital invested in a stock that takes several years to recover could potentially have generated better returns elsewhere.

This leads to another important portfolio management concept: opportunity cost.

Opportunity cost: Capital trapped in an underperforming investment

Opportunity cost refers to the potential returns an investor misses by keeping money invested in one asset instead of allocating it to another investment.

When a stock experiences a significant decline and continues to underperform, the investor’s capital remains exposed to that company’s future performance.

Let’s consider an example.

An investor purchases $20,000 worth of shares in Company A.

The stock declines by 40%, reducing the investment value to $12,000.

The investor now has two broad considerations:

• Continue holding the stock in the expectation that its fundamentals and share price will recover.
• Reassess the investment and consider reallocating the remaining capital to other opportunities.

Assume the remaining $12,000 is invested in another asset that subsequently generates a 10% return.

The investment would increase to $13,200.

However, if the original stock remains unchanged, the investor’s capital stays at $12,000.

The difference is $1,200.

This illustrates how a poorly performing investment can affect portfolio performance not only through the initial decline but also through the returns that could have been earned elsewhere.

It is important to remember that selling a losing stock does not automatically improve portfolio performance. The decision should depend on the investment thesis, company fundamentals, valuation, risk and alternative opportunities.

The compounding effect of holding a losing stock over time

Another important issue is the impact of losses on long-term compounding.

Compounding allows investment returns to generate additional returns over time.

However, when a portfolio experiences a substantial loss, its capital base becomes smaller.

This means future returns are calculated on a reduced amount of capital.

Consider the following example:

An investor starts with $100,000.

• In Year 1, the portfolio declines by 20%.
• In Year 2, the portfolio generates a positive return of 10%.
• In Year 3, the portfolio generates another positive return of 10%.

Despite generating positive returns in the following two years, the portfolio is still below its original investment value.

This demonstrates why avoiding large losses is an important part of long-term portfolio management.

A substantial loss requires significantly higher future returns to recover the original capital.

Despite generating positive returns in the following two years, the portfolio is still below its original investment value.

This demonstrates why avoiding large losses is an important part of long-term portfolio management.

A substantial loss requires significantly higher future returns to recover the original capital.

Lauren Hua is a private client adviser at Fairmont Equities.

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