Investing Tip #2: Diversification, Part Two

It’s amazing the difference in coloring skills between my three year old and my four year old.  My four year old uses a lot of different crayons to color in her coloring book.  Red, blue, orange, green—they all manage to get on each paper.  I think she does a better job than I do coloring. 

My three year old hasn’t seen the benefits of crayon diversification yet.  She uses just one crayon (usually purple) to color everything on the sheet.  The grass, the bunny, the clouds, everything—all purple.  Now I have no doubt that she will soon start using other crayons and color just as good as her sister—it’s just an age thing.

Sometimes though, we adults color with only one crayon.  We have too much of our hard-earned investment dollars tied up in just one or two investments.  Often, it’s the stock of the company at which we work.  Or it may be just a few individual bonds since investment minimums are usually much higher than stocks. 

Individual Company fortunes can change in a heartbeat.  The founder passes away.  The CFO has his hands in the till.  A new law strangles the business model.  The competition develops a product that completely eclipses yours. 

There is the possibility of these risks with every investment, sometimes we can see it coming.  Most times, we can’t. 

One of the most well-known examples for me was Corning, Inc. which had a factory in State College.  Corning, like all technology companies in the late 90’s and early 2000s was going gangbusters.  It was leading the charge in fiber optic cable, the wave of the future. 

The stock doubled from $30 in January to $60 in November 1999.  Then, over the next three months, it doubled again.  Seemingly invincible, it shrugged off the Nasdaq’s peak in March 2000, and nearly doubled again by August, reaching a high of almost $115.     

      Source: eSignal Data                  

Working at Corning during this time was interesting to say the least.  Those who had their 401(k) full of Corning stock were seeing incredible returns.  And those who didn’t felt left behind.  Many threw caution to the wind, and ignored the rules of diversification.

But all good things come to an end.  Often, it ends with a bang.  10 months later, Corning was again trading at $30, where it had started its incredible 360 degree journey two and one half years earlier.

I know of many who were wiped out in this bubble.  One person had $750,000 in his 401(k) at the top.  The last I spoke with him, it was $38,000. 

How often does this kind of stuff happen?  More often than you might think. 

So how many different stocks, bonds, and real estate properties should you own?  It doesn’t have to be a thousand.  According to Frank Reilly and Keith Brown In their book Investment Analysis and Portfolio Management, “about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks."

Having twenty stocks gives you about the same diversification benefit as owning all 500 stocks in the S&P 500 Stock Index.    

So you don’t need a lot.  Just more than one.