There are certain ‘truths’ in investing that no one can deny or ignore, one of the first we all come across is the idea the Reward of an investment is always reflected by the Risk of that investment.
Which elevator would you feel more confident in?
Hitting the button to call the nearest elevator to pick you up on the 37th floor, you look out the window and admire the view just for a moment. From this height, you can see the downtown skyline all the way out to the lake view houses, it is awe inspiring.
‘Ding’ the elevator has arrived.
Cruising down 37 flights is abrupted suddenly when you begin to feel a little rumble. ‘Not now, not now’ is the only thing that can cross your mind as you feel the beginnings of an EARTHQUAKE!!!
Suddenly, the view from a few moments ago is not so much awe inspiring as awful to visualize. Quickly you think ‘what is connecting the elevator car to the building?’
Imagining if this is an old building, they probably didn’t have as stringent protocol for earthquake testing and there is probably only one cable. One fateful wire that is holding you from a 30-foot free fall! This thought is almost too much for you to handle.
Now, what if the elevator was prepared for this earthquake and had 4 or even 5 cables connecting the elevator car to the building roof. Would you feel safer?
No one can predict when this moment would occur and even though you are not happy with the timing of the quake, you will at least have some security in knowing all your eggs are not in the basket of that ONE cable!
As clear as this example is when you envision yourself swinging in an elevator 30 flights in the air, many people do not practice this concept with their money. This principle of diversification does not translate for many who are investing, they believe if they go all in on one investment, they could hit a home run!
No matter if you are just opening your first account or have $1 Million portfolio, betting on a single company is a risky venture. Regardless of how massive the company, it is only a matter of time before its stock price, your nest egg, takes a hit and leaves you sick.
Jeff Bezos who has famously become wealthy by going ‘All In’ on Amazon understands that every dog has their day and it is only a matter of time before even his giant is slain. ‘Our job is to push off the inevitable, that is the fact our company will go away’ Bezos states in an interview.
Has Amazon been the Unicorn who has seen their stock price skyrocket year over year? Yes, but for every Amazon, there are thousands of other companies that not only lose money but fail altogether.
Casualties even include behemoth companies that felt like sure things. Take Enron, who saw their stock price reach an all-time high of $90.75 before tumbling only two years later to $0.12. Or how quickly Washington Mutual was sold after the bank failed during the 2008 crisis.
Diversification is Key
Sometimes people don’t even realize they are concentrated on one stock because they are too close to the investment, they work there. Companies have chosen to give you an opportunity to participate in the growth of the company by issuing you stock or allowing you to invest in the company stock in your 401(k). Both are valuable benefits, but you must be careful not to commit too much to the place that your future income is also depended on. This is putting your present income and future income back in that elevator with one cable.
The Pacific Gas and Electric Company (PG&E) based out of California has seen 25% drops in its stock price with the rolling blackouts and fires. There is over a billion dollars of PG&E stock in the company 401(k)!
Imagine being 3-5 years from freedom and a single event delays you for years.
The investment truth is ‘risk equals reward’ and when your investment portfolio is highly concentrated on one company, the reward can be high, but the risk can be even higher.
When building your portfolio remember that feeling of being in an elevator with only one cable to depend on.
Remember these two thoughts in your portfolio construction:
- Diversify your portfolio within each asset class by having a variety of sizes (small, mid, large) and evaluations (growth and value).
- Diversify your portfolio among each asset class by having different asset classes such as secure and high-income bond fund; domestic and foreign equity; and real estate exposures.
By focusing on the reward of your plan, you can build out how much risk you need to take on to achieve your goal. The objective is to reach your goal, not have the best single year return story at a cocktail party.
Naturally the question then becomes, ‘How big does my reward need to be?’