Diversification

Risk is inevitable. All investments have some sort of risk. For instance, bonds have default and interest rate risk. Foreign stocks have currency and political risks - REITs have vacancy risks.

CDs, although relatively safe, aren’t risk free. 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 to name but a few. Anyone who owned shares in these companies lost money, a lot of money, which reminds me of a 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.” But I was hoping against hope that I was reading this statement incorrectly. 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, it had a balance of less than $100.00. The widow 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 just about nothing.

I wish I could describe the look on her face when I confirmed they had lost all their money, and indeed, she was broke. I can’t imagine what that must have felt like. Elderly, widowed, and penniless.

I recorded a podcast, not too long ago, called “Women and Investing.” I would encourage the ladies reading this to listen to it when you get a chance. It deals with the problems women face with the death of a spouse or divorce. You need to be aware of and involved in your family’s financial decisions. Visit GreatInvestor.org. It’s free and informative.

So, why is a diversified portfolio paramount? Number one, because it’s biblical. In Ecclesiastes 11:2 (NIV), Solomon said,

Invest in seven ventures, yes, in eight, you do not know what disaster may come upon the land.

Why diversify? Because you are 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 component of reaching your long-term financial goals while, at the same time, minimizing risk.

Why diversify? Because risk can be hidden and is often unquantifiable. One of the biggest risks we face is that of an unknown future event like 9/11, and how such an event might affect our investments.

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. Many airlines filed for bankruptcy protection; some went out of business. After the horrific events of September 11, those who survived saw their share prices decline by 70-90% in the months following. That’s just one reason you should take Solomon’s advice and don’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.[*] 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 the next year, and fixed index annuities the following year. Because none of us can know the future with any degree of certainty, buying multiple (7-8 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 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 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 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 that I shared with you earlier 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 do not know what disaster may come.

If you would like to learn more about how you can become a better investor, pick up a copy of my latest book, How to Be a Great Investor – Investment Techniques for Christians. It’s available on Amazon in paperback and Kindle. You can also order it on GreatInvestor.org.

Thanks and Blessings,

Richard Everett

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