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Bruce W. Kaser, CFA
June 03, 2019

Three Key Ways to Reduce your Turnaround Investing Risk While Improving Your Returns

It is easy to get mesmerized by the potential gains in a turnaround stock and put in too much of your money. Even if you avoid most of the common turnaround investing mistakes, events may not work out the way you expected. The best way to manage this risk is through diversification.


While important to any investment program, diversification is critical to successful turnaround investing, as turnaround investing carries higher risk than traditional stock investing. Some turnaround stocks will produce large returns, others small returns, and some may even produce large losses. If you diversify, however, an unlucky pick or two may be more than offset by one or two big gains from other turnarounds that you own.


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Two important components of diversification are your risk tolerance and your turnaround portfolio’s size relative to your overall portfolio. You don’t want your turnaround portfolio to inject too much risk into your overall portfolio. Each investor has different levels of comfort in evaluating how much risk is “too much”. While there are many quantitative and complicated ways to measure your risk tolerance, one often-used and straightforward measure is: if your portfolio keeps you awake at night, you are taking too much risk. Many savvy investors consult professional investment advisers to gauge how much risk is appropriate for them.


There are a few types of diversification to think about:

1 Number of holdings

The more names you own, the lower the impact of any one investment. With a large number of holdings, say, 50 or more, if one of your stocks does very poorly, the others will dampen the effect on your overall portfolio. However, this works both ways – a truly outstanding stock won’t have much impact if you hold too many stocks. Many turnaround investors find that a portfolio of 10-20 stocks provides adequate diversification, yet doesn’t overly suppress the impact of a big winner.

2 Sectors

Hold stocks in several unrelated sectors. That way, if, for example, oil prices fall sharply, your holdings of oil companies won’t overly depress your portfolio’s value. A portfolio that is diversified by sector might include stocks in the consumer staples, industrials, energy, health care and consumer cyclical industries.

3 Turnaround life-cycle

Turnarounds usually take time to work, in some cases as many as 3-4 years. Companies that are in the early stages of their turnaround often have weak stock returns until evidence of recovery is in place, whereas stocks of later-stage turnarounds can be very strong. If you own too many early-stage turnarounds, your portfolio can suffer. Ideally, a turnaround portfolio includes early, mid and late stage turnarounds. For investors building a new portfolio, you can start with the early-stage stocks, and gradually add new ones as your holdings reach the sweet spot.

Why not own only late-stage turnaround stocks?

With a late-stage turnaround, you can’t tell ahead of time when a stock will surge and when it will have a pull-back. Even the best turnaround investors can’t always predict which investment they hold will be their best or worst performer. Also, if your early-stage holding becomes a strong late-stage stock, then has a temporary set-back, you will likely feel more comfortable holding it. However, if your just-added late-stage stock has a set-back, you might be tempted to sell your new money-losing position at the wrong time.

Improving your returns

While diversification can reduce your risk, it carries another benefit that is just as important: it can improve your investing returns. When properly diversified, you will likely have the tolerance to hold onto an early-stage turnaround that is going in the wrong direction. You don’t want to be shaken out of a position on temporary bad news that startles the market, or lose patience and sell because a turnaround hasn’t works “fast enough”. These can be the exact wrong time to sell. In some cases, these stocks can become the strongest winners, lifting your overall portfolio’s returns.

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While important to any investment program, diversification is critical to successful turnaround investing, as turnaround investing carries higher risk than traditional stock investing.