Investments and Diversification

Aesop said, “Don’t put all your eggs in one basket. “ Or maybe it was Benjamin Franklin. Anyway, it was one of those know-it-alls.

That homily applies to your investments as well. Once you have an asset allocation plan, you will have to fill up your stock percentage with various stocks, and your bond percentage with various fixed income investments. One rule that should guide that process is the principle of diversification. Do not have too large a percentage of your stocks in the stock of any single issuer, or in any single industry, or even in any single financial sector or country. Why? Because by concentrating your assets in one company (or industry or financial sector or country), you run the risk that a single adverse event, always unanticipated, can decimate your retirement fund. That’s an extra risk you do not need to take. By spreading your stocks among a number of companies (and industries and financial sectors and countries), you increase the likelihood that a downturn in one company (or industry, financial sector or country) will be offset by superior performance elsewhere. The risk of concentration is potentially enormous (think Enron).

Moreover, according professor and economist Burton Malkiel in his classic book A Random Walk Down Wall Street, many financial professionals believe that the markets do not even reward you with any extra return for taking that extra risk. What a lousy deal that is!

How much concentration is too much? Opinions differ, but a good rule of thumb is to avoid having more than 5% of your stocks in any single issuer. That’s 5% of your stocks, which is an even smaller percentage of your overall investments.

There is one particular type of concentration problem to be wary of: owning too much stock in the company you work for. That’s an easy trap to fall into. Companies often like to fill up their 401(k) plans with their own stock. They often make matching contributions in the form of company stock. Or they make company stock the default investment option. They sponsor ESOPs, which by design are intended to be invested primarily in company stock. They sponsor plans that enable employees to purchase company stock at a discount. They reward employees with bonuses in the form of shares of stock and stock options. Companies like to do this because it supposedly encourages employees to work toward profitability for their own benefit. But it adds extra uncompensated risk to your investments.

And, worse, looking at your bigger financial picture, if your company goes under, you lose your job at the same time your portfolio gets decimated. Again, think Enron. So it’s a good idea to keep an eye on how much company stock you own, directly and indirectly, and adjust it downward where you have the power to do so, if the percentage gets too high.

I understand that your company is different. It’s not Enron. It’s the beast of its industry. I don’t care! It’s good to be loyal and true to the home team, but at some point it’s prudent to put a cap on your loyalty.