Monday, March 2, 2015

Step 4 - Diversify Your Investments

Enron, WorldCom, Lehman Brothers, General Motors, American Airlines, Radio Shack. Notice anything similar between all of these companies? Every one of them for one reason or another declared bankruptcy. What that means to an investor is that if you owned stock in those companies, you would have lost your entire investment. Most of these examples are well known, but this is something that occurs fairly often and without a lot of attention (how many companies can you name that have declared bankruptcy in the past year? There have been several). The takeaway from these examples is simple – don't invest too much of your portfolio in any one company.

Of course, the counter argument is that if you just put all your money into something like Apple that has gone up a lot lately, you could have grown your portfolio by >20x in the past 10 years. True, but good luck figuring out what stock is going to do that over the next 10 years. In order to diversify a portfolio, you should have several different stocks. By doing so, you reduce the risk that a catastrophic event for one of your stocks wipes you out, but you also give up the opportunity for significant gains that can occur with individual stocks. The most successful investors I have met didn't grow their assets to significant levels by being heavily invested in a single stock, nor did they put their wealth at risk by investing it heavily in an individual stock.

Other than simply not knowing any better, there are a few reasons that I have seen investors hold what I would consider 'too much' in one stock. Here's what I have to say about them:

  1. "I work at 'XYZ company', I know what we've got coming down the line, you won't believe how great it's going to be" (often accompanied by a wink, wink). Or "I'm ok having half my nest egg in this stock because I work there every day and I can keep an eye on what's going on with the company."

    • You very well may know what's coming down the line from your division, but unless you are one of the top 5 or so people in the company, there is no way you know everything that is going on in the company and what your competition is doing before that information is already priced into the company stock.

    • There are probably several stock analysts out there that know your companies financials way better than you do. These analysts are just as familiar with the financials of all your competitors and have a much better idea than you of how your company stock will perform relative to the competition.

    • If you have a lot of stock in the company you work for, it is actually riskier for you than it would be for someone else who doesn't work for the company. If things went south for your employer, not only is your nest egg at risk, but so is your job. Double whammy!

    • If you really have enough time at work to 'keep an eye on' every facet of the company to know what is going to impact the stock price, and you're not the CEO, eventually someone will figure out that you don't actually do anything at work and probably aren't really needed.


  2. Similar to the Apple counterargument to diversification, I have seen people fall in love with companies, either for their products, or simply because the stock has gone up a lot recently. Somehow this love for the company translates to an investor believing that they should dump most of their money into that companies stock. Apple is one example of this, but I have also seen investors get attached to automotive stocks (Ford, GM, etc), consumer staples stocks (P&G, Johnson & Johnson, etc), entertainment stocks (Disney), and Biotech/Pharmaceutical companies (Pfizer, Genentech, etc).

    • It was once said that "what was good for our country was good for General Motors, and vice versa". Putting all of your money into GM may have sounded like a good idea at that time to some people. My how things have changed. I'm not predicting anything bad for any particular companies, but just remember that there is no stock that has consistently been the best performer.

    • When you develop this sort of obsession with any company stock, it makes it difficult for you to view it objectively and you can find yourself making excuses for poor management decisions and saying things remarkably similar to things you could hear from a gambling addict ("I'll sell when it gets up to X", then after it reaches 'X' you move your target sell price up, or "I'll sell it if it drops to Y", then when it does, you make excuses for why it shouldn't have dropped in price, it's a short term correction, it will be back, etc…).

    • What exactly is your strategy? Faith and hope are great attributes, but they are not an investment strategy.


  3. "I can't sell now, I've made so much the taxes are going to kill me".

    • You only pay taxes on your gains, not the entire sale amount. Even if you invested $1,000 and now it has grown to $100,000, it's not like you won't have the cash to pay the taxes, since you will get the full $100,000 when you sell.

    • The downside risk you take by holding a stock is always significantly more than the taxes you may have to pay if you sell. Mathematically, this doesn't make sense. If you invested $20,000 and your investment is now valued at $50,000, you are risking $50,000 to save $4,500 (50,000 – 20,000 * 15%) by not selling and locking in your gains.

I have read books that claim that diversification is a bad idea and that you'd be better off making big bets with big payoffs. The only problem with that strategy is that even with the risks being calculated, it is still a bet. For every investor who has made a fortune with this approach, there are hundreds of investors whose stories you won't hear because they lost everything trying the same thing. Diversification certainly isn't as exciting or sexy as some of the other approaches, but IT WORKS.

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