Risk & Diversification

Beloved, I pray that you may prosper in all things and be in health, just as your soul prospers. (3 John 1:2 World English Bible)

All investments carry some degree of risk. Bonds have default and interest rate risks. Foreign stocks have currency and political risks. REITs have vacancy risks. CDs, while relatively safe, aren’t risk-free either. Penalties for early withdrawal, inflation, and taxes can erode your savings in a hurry. Companies go out of business or file for bankruptcy all the time—Lehman Brothers, General Motors, Toys “R” Us, and Enron are just a few prominent examples. Anyone who owned shares in these companies lost money—a lot of money. It reminds me of a sad story.

Years ago, an older woman had an appointment to see me for the first time. While wiping away her tears, she said to me, “I doubt you can help me.” As she handed me her brokerage statement she told me her husband had just passed away and that she had never been involved in any of their financial decisions. When I took a look at the brokerage account I saw that it had a balance of less than $100. The woman went on to say that her husband had invested their entire life savings in Enron stock. What used to be a half a million-dollar account was now worth next to nothing.

I wish I could describe the look on her face when I confirmed that she and her late husband had lost all their money, and that she was indeed broke. I can’t imagine how she must have felt.

I recorded a podcast called “Women and Investing.” I would encourage the women reading this to listen to it. I talk about the problems some women face with the death of a spouse and divorce. All of us need to be aware of and involved in our family’s financial decisions.

Visit GreatInvestor.org. It’s free and informative.

This leads me back to why a diversified portfolio is paramount. First of all, it’s biblical. In Ecclesiastes 11:2 (NIV) Solomon says, “Invest in seven ventures, yes, in eight, you do not know what disaster may come upon the land. Why diversify? Because you’re crazy if you don’t.

The purpose of diversification is to maximize your return by investing in different asset classes that do not react the same when an event happens. Diversification can be the most important step to reaching your long-term financial goals while, at the same time, minimizing risk.

Moreover, risk is difficult to detect and quantify. Take the horrible events of 9/11 for example and how that single day affected the investment world.

There’s a big difference between probability and outcome. Probable things fail to happen, and improbable things happen all the time. That’s the most important thing you can know about investment risk. –Howard Marks

Imagine owning airline stocks on 9/10/01. Soon after 9/11/01, many airlines filed for bankruptcy protection. Some even went out of business. And in the following months, prices declined by 70 to 90%. That’s just one reason you shouldn’t put all your eggs in one basket.

Proper diversification helps reduce risk and volatility by investing in multiple asset classes (stocks, bonds, commodities, etc.) that are non-correlated.[1] You can smooth out some of the bumps in the road you’re bound to face.

Stocks may be the top performing asset class this year; REITs next year; and fixed index annuities the following year. Because none of us can predict the future, buying multiple (7 to 8 as Solomon suggests) investments can assure us of having some of our investment dollars in the right place at the right time. With a diversified portfolio that suits your financial risk tolerance and long-term investment objectives, you may be able to live happily ever after.

If you do not properly diversify, you may end up in my next Newsletter as another horror story.

Now that you know what diversification is and why it’s important, let’s be crystal clear on what diversification is not.

It’s not owning three equity mutual funds, or five CDs at different banks, or four annuities with various insurance companies. If you own more than one mutual fund that owns the same stocks in each of their portfolios, you are not diversified! If you own multiple rental properties that make up the majority of your net worth, you are not diversified. What will happen to you the next time we encounter another real estate collapse like we did in 2006—2012? Don’t make the same mistake the widow’s husband made by investing everything in a single stock. Don’t put all or most of your investable assets in a solitary asset class. You are asking for trouble if you don’t heed the wisdom of the ancients, Invest in seven ventures, yes in eight, you don not what disaster may come.

Please make sure you take advantage of our financial resources on GreatInvestors.org, the only website dedicated to teaching Christians the art of investing. Please follow our Facebook page and like and share us.

Thanks and Blessings!

[1] The price of one asset has little or no effect on the price of another asset class.