Portfolio Diversification
The Smart Profits Report: Issue #296
March 30, 2006
Portfolio Diversification: Falling In Love With Investments Can Cost You MillionsBy Steve McDonald
Advisory Panelist, Mt. Vernon Research
Ten years ago, when I was working as a stockbroker, I had a client who did something pretty remarkable. Something, in fact, I may never forget… This investor steadily, over the course of 18 months, went about turning several million dollars into several hundred thousand dollars.
So how did he manage that sad feat? Simple… By not listening to good advice.
Fact is, one of the toughest things for a broker to do is not, as many investors think, simply provide well-researched investing ideas. No, the toughest thing is getting clients to listen to you…
Although I left the field long ago, the one rule I try to drive home to this day - and perhaps the most fundamental rule for making and retaining wealth - is this: portfolio diversification.
Although it may sound simple - and you’ve probably heard it a thousand times - putting this simple idea into play may do more to make and save you money than most other investing maxims. Let me explain…
One Nest Egg Is Not Diversification
Back then, my client refused to diversify his portfolio. And he paid dearly. Imagine putting all of your earnings - everything you had saved - into just one company. And imagine hitting the jackpot. That’s right, the stock was an extraordinary performer.
By way of instruction, here’s what happened…
My client had been a very successful businessman. He was preparing to retire and needed help transitioning from his 401(k), company stock options and company stock into a retirement-style investment program.
There was one hitch. Although he had assiduously saved money over the years and plowed a substantial amount into his retirement funds, my client had done something wrong: All of his money was tied up in one company.
I recommended he liquidate at least 75% of the stock and options and set up a diversified portfolio of blue chip, dividend-paying stocks and bonds. My plan would have given him much more safety, simply by spreading the risk. He would also receive the desired income in his retirement years.
My client’s response is as clear now as it was then. “Steve, I wouldn’t have anything if it had not been for this company. I will stick with them. I know them and I know how they do business. I appreciate your input, but I’ll stay put.”
A Falling Star - From $78 To $8 A Share
Between that conversation and the end of 2002, the stock dropped from $78 to $8. You do the math. The company also cut the dividend to almost nothing. I was no longer a broker when the stock market started its three-year correction, from 2000 to 2002. But I have thought many times about what I could have done differently. The answer is always the same: nothing.
My client’s thinking was focused on issues that had nothing to do with making money or portfolio diversification. Either one of these reasons is virtually impossible to overcome when you are working with a client.
First, he confused investments with feelings, memories and dedication. If you have any reason for owning an investment other than making money, you’re dreadfully mistaken. My client had a misty-eyed memory of a young man going to work for a good company that gave him every opportunity to excel and make a better life for himself. Very commendable, but it has nothing to do with making money.
Investments Are Not Collectables
Investments exist for one reason - to make money. And to make money with them, you must sell them, not hold onto them as you would your favorite collectables.
Second, at the time of our conversation, broker commission rates were much higher than they are now. Before the advent of online investing, the average stock trade cost a minimum of $100. To sell one stock and make dozens of purchases would have cost several thousand dollars. Most people want to believe they are getting something for nothing, especially in the investment business. My client was no different.
He focused more on the cost of doing business than the returns he would reap with diversifying his portfolio. Nine out of 10 clients think about cost before return. What many people end up doing is saving pennies and losing dollars. In this case, millions of dollars.
Good Trading,
Steve
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Today’s Smart Profits Cribsheet
- See our recommended reading section for books on trading derivatives. A great primer on options trading is Lawrence G. McMillan’s Profit with Options: Essential Methods for Investing Success. This is a course book that covers every phase of the options trading process. It takes a step-by-step approach, reinforcing concepts through quizzes at the end of each chapter.
- Which company first made IPO shares available to the public? Answer: the Green Shoe Company. And that’s why a “Greenshoe Option” is one that allows the underwriter of an IPO to sell additional shares to the public if the demand is exceptional. See the Smart Profits Glossary for other useful terms such as “diversification” found in today’s article.
Related Articles:
- Principal Protection: How to “Defend” Your Principal From a 50% “Bomb”
- Trading Index Options - Two Ways To Profit
- Fair Value Sheets: Quote, Trade and Hedge… In Less Than 30 Seconds
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