Harry Markowitz
“Diversify, Diversify, Diversify.”
Even if you loved it soooooo much, would you choose to eat chocolate daily and nothing else?
To diversify–to NOT put all your eggs into one basket–is one of the few absolute rules of investing. When you invest, you want to build a portfolio that holds a variety of different assets, across asset classes, and across geographical markets. We do this to protect ourselves from market volatility or unpredictable recessions.
Take Enron as an example and the lessons that we learned from that. Founders Jeff Skilling, who ultimately went to jail, and Ken Lay, who died while awaiting trial, who established a 401(k) retirement plan for their employees, offering many options for saving that would be deducted from each pay period. One of the options was to put those contributions into Enron stock. Like so many confident and faithful employees, one Enron secretary sank her life savings into the Enron stock option, and consequently, once the fraudulent founders were uncovered, she lost all her retirement savings. Not only did she fail to diversify investments, but she was so caught up in the miraculous early gains of the company that she was blinded to the downside possibilities inherent to all individual stocks at any time.
Just as you need to diversify by holding different individual stocks in different industries, you must also diversify by holding different asset classes. Bonds can temper the risk of a common stock portfolio. For example, in 2008, when the market declined and stock prices fell in both the US and foreign markets, bondholders experienced minimal losses compared to their stockholder counterparts. At that time, a worldwide recession was anticipated, but the U.S. Treasury bond portfolio rose in price because authorities lowered the interest rate to stimulate the economy. When interest rates fall, bond prices tend to rise.
Keep in mind that other asset classes can also reduce risk. Commodities such as gold can hedge against inflation, and real estate can provide a whole different spin to your portfolio, achieving the ultimate gain—diversification.
A financial planner who recently appeared in a publication for fee-only financial planners compares an investment portfolio to what we eat. The more food groups and colors on your plate, the more nutrients your body consumes and the healthier you are.
To answer the question we began with, if you only ate chocolate daily, your body clearly would suffer from a lack of key nutrients. The same is true for an investment portfolio. Investors who put their money in only one type of security are at an increased risk of losing principal due to a lack of variety in their portfolio.
Don’t eat only chocolate. Diversify, Diversify, Diversify.
Links for Further Reading:
https://www.investopedia.com/investing/importance-diversification/
