Remember Enron? I think we all do. Enron was once a powerhouse company that saw its empire crumble and took the wealth of many of its employees with it. Why was that the case? Many of Enron’s employees had their 401(k) retirement savings in Enron stock. This was the classic example of having all of your eggs in one basket and zero diversification.
Let’s say that the employees had half of their retirement in Enron stock and half in a mutual fund. Enron tanks but their mutual fund stays afloat. This means that they lost, but only lost half of their retirement, all else being equal.
Imagine if they had only a quarter of their retirement in Enron and the remaining 75% in three separate mutual funds. Enron’s demise is only responsible for a fourth of their retirement evaporating. This could go on and on.
The point is that when you choose to diversify you’re spreading your risk among a number of different companies. That way if one goes belly-up you’re not left with nothing.
Mutual funds are an excellent way to diversify among an asset class. For example, if you purchased a total stock market index fund you’d have nearly the entire US Stock Market in your portfolio which amounts to approximately 4,100 different stocks.
That’s great diversification but we can do better. The US equity market is only one area. We can diversify into domestic bonds, international stocks, international bonds, real estate, and so on. This is called diversifying among asset class. The point is that you want to spread your risk and diversify as much as possible so one market or asset class doesn’t ruin your entire portfolio.
A term we use often in the industry is correlation. This simply means how one particular security moves in relation to another. If I own two large cap growth funds they’re pretty closely correlated; meaning that if large cap companies fall both of these funds are going to fall very similarly.
If I own a large cap fund and a bond fund, then if large cap stocks fall, the bonds may rise or may stay the same or even fall slightly. This is because they are a different asset class and move differently than equities. Keep adding different assets to the mix and you have a potential portfolio that can withstand the dip and turns of the market.
Even the Oracle of Omaha, Warren Buffett diversifies. Granted he may have all of his eggs in one basket, Berkshire Hathaway, but own Berkshire Hathaway stock and you’ll get exposure to insurance, bricks, candy, cutlery and underwear to name a few. Admittedly, not many people have $175,000 to buy just one share of BRK stock, but the point is that even Mr. Buffett diversifies.
Diversify. It works.