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Tuesday, June 1, 2010
The very first investment principle a DIY Investor should learn - one that is learned by some at great cost (monetarily and psychologically)- is don't put all your eggs in one basket.
Many of the employees at Enron didn't understand it, but I bet you today they get it.
Every advisor who has been in the business long enough flinches whenever they see a major stock run into difficulty because they know someone who holds the stock who wouldn't reduce their exposure. For example, I pleaded with an elderly lady in 2006 to reduce her 28% holding of a major bank stock she had inherited from her mother. She liked the dividend she said, but I knew the real issue was emotional attachment because I showed her a number of stocks in different industries that paid close to the same dividend. Needless to say, I didn't get that account because she didn't want to hear the advice I gave.
Today I think back to a lady who had inherited BP stock and couldn't part with it. The shares had been given to her by her dad to finance her retirement. I can only imagine the sleepless nights she must be experiencing now.
Here's the rule: limit exposure to 5% of total investable assets in any one name (stocks and bonds combined). When the price rises to put exposure at more than 5%, reduce the position. If there are tax consequences, then manage these.
This comes from someone who has been stunned by developements in recent years by the companies that have run into difficulties: Bear Stearns, Lehman, Citi, Bank of America, AIG etc.
Remember: Fortune magazine was praising Enron right up until it imploded despite having no clue on how it achieved its earnings.