There's no time like the recently-passed 10-year anniversary of the Enron wipeout to revisit some solid pieces of investment wisdom. And one of those nuggets is of such all-encompassing sagacity that it can be easily summarized in a single word.
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If you'll remember the Enron affair, so insightfully captured in “The Smartest Guys in the Room,” as the fraudulent energy giant teetered on disaster's brink mere days before crashing and exploding in a spectacular fireball, CEO Ken Lay and his minions exhorted employees who had placed their life savings in Enron stock to avoid selling their shares.
I'm sure you know the rest of story… When Enron immolated, those workers had nothing left to show for years and years of faithful toil and investment. As we marked the decade anniversary, some former Enron workers who once enjoyed nice nest-eggs still struggled from the catastrophe that befell them in 2001.
I don't claim to be an investment guru. But I have spent a lot of time chatting with financial oracles and savants, and have no reluctance passing along their guidance to investment novices. What I hear from the experts is that too many people invest too close to home for their own good. While they ought to be casting a wide net, their investments are about as far-flung as the confines of a toddler's playpen.
In other words, diversification isn't just about investing in diverse asset classes. It's also about investing in a geographically diverse assortment of equities.
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The tendency of many to invest close to home begins with backing their own employers with their hard-earned dollars. They figure it's a vote of confidence in their own futures to buy shares in the firms employing them. Nothing is further from the truth, as the “little people” at Enron discovered.
When their company died, not only were their jobs wiped out, but most or all of their portfolios were as well. Had they invested no more than 4% in any one stock, a figure often suggested, at least 96% of their stock investments would have been saved from the conflagration.
If it's wise to ensure your portfolio is well diversified outside your own firm, it's almost as brilliant to avoid investing heavily in companies in your home city, state, or region. Years ago, I spoke on that topic with Larry Swedroe, the St. Louis-based author of “Investment Mistakes Even Smart Investors Make and How to Avoid Them.”
“People make the mistake of confusing the familiar with the safe,” he told me. “Take a guess what people in Georgia own a disproportionate percentage of stock in. Coca-Cola. Guess what people in Rochester, N.Y. have traditionally owned more of. Not only is stock in Coca-Cola not a safer investment for people in Georgia, it may be a riskier investment. Because if something major happens to the company, what will happen to home values and job opportunities in Georgia?”
Imagine a regional economic shock impacts your neck of the woods. Your home turf is locked in a slump, affecting your job security and likely your home's value. But it's not just those items impacted, it's also your portfolio, because you invested disproportionately in area firms. You need ready cash, but to get it, you may have to sell stocks in regional companies at the worst time, when their prices is low.
Adopting a world view
Taking this approach to the next logical level, does it also make sense to avoid having all your stock holdings in U.S. companies? You bet it does, and for many of the same reasons. Virtually any Yank is going to be tempted to feel the all-American firms he or she grew up with will be the ones that pose the least risk. But that's just again confusing the familiar with the safe. “People in the United States think U.S. stocks are the safest,” Swedroe remarked to me. “And guess what people in France think?”
Gaining international diversification is like buying insurance that covers potential problems here in the United States, he noted. “Some years you collect, and some years you don't,” he said.
“But you don't complain in years you don't collect on your insurance, because you didn't die or your house didn't burn down. Owning international stocks is like that. In years when they do poorly, that's the price of insurance.
“But you get a smoother ride over the whole period.”
If you're invested only in American companies, you're ignoring a world of opportunity. More than half of all investment opportunities lie outside the borders of this country. And many of those in emerging economies have more upside than opportunities here. Some experts suggest even firms in other developed countries have more room to run than U.S. companies. That means you may be getting in on long-term growth potential by investing internationally.
All about correlation
What it all boils down to is you want low correlation in the stocks you own. When stocks are not correlated, they're diverse. Stock holdings in many countries around the world? Lower correlation. Stock holdings only in the U.S.? Higher correlation. Stock holdings just in your city or region? Still higher correlation. And stock held only in the company in which you're employed? If it could accurately be called correlation at all, that would be correlation on steroids.
If someone at the publicly-traded company that employs you suggests you place most of your investing bets on your own employer, keep this in mind. They're likely not the smartest guys in the room. But they may be the most sinister.
The original article can be found at FiveCentNickel.com:
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