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Tuesday, June 1, 2010

A fundamental rule of diversification

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.


  1. I work with several Worldcom "millionaires" who put their entire 401Ks entirely in company stock. They rolled the dice and lost, and instead of retiring in their late 30's or early 40's as they initially thought when Worldcom was a go-go stock, they are looking at retiring in their 70s, if at all. My rule of thumb is own 0 stock in the company you work for (except in mutual funds and indexes) because you already have enough at risk with your paycheck and benefits. Maybe a little extreme, but better safe than sorry.

  2. I do agree with your general rule of thumb about limiting any individual asset to 5% of the portfolio. Being a conservative investor, and knowing I'm no Warren Buffett, I would probably cut that number in half.

  3. Grouch: I have no problem with 2.5%. There is a tradeoff though in that it increases the number of stocks you have to follow. It is one reason I recommend ETFs for most investors - at least for 80% of their investable assets.
    I liked the WorldCom example. I didn't know any of those "millionaires" but I do know that today there are Oracle executives overloaded with company stock - especially when you take into account the options they've been granted.
    A related issue is to be careful you are diversified by industry. Being overweight in banking moving into 2008 would have been costly. This is a tricky issue to handle sometimes for individual investors.
    Your point on owning stock in the company you work for was well taken.

  4. I have a friend who works for Telus (wages paid by Telus) and she'll get a pension (paid by Telus) and she guessed it...Telus stock. Talk about a triple threat.

    You guys are all "bang on" with your advice and comments.


  5. There's a transferance problem with this issue. You explain to people about "too many eggs in one basket" and they all nod and claim they understand it completely. Then you get to the detail of their situation and they are surprised that they are in a triple threat state like your friend.