Why Diversification’s Important To Your Portfolio

| January 2, 2009 | 0 Comments

These last few weeks, it’s been all over the news.  Bernie Madoff … “made-off” with billions of dollars of his investors’ money.  His giant Ponzi scheme ran for more than 30 years.  It finally crumbled at the end of last year.  I can’t believe the number of people caught in his web of deception.  The part I find most shocking is not the amount of money he stole, but the types of people he was able to con.

He managed to scam some of the smartest people on Wall Street.

His list of victims reads like a who’s who of financial investing.  CEOs, CFOs, portfolio managers, institutional investors, business people, even charitable foundations.  Investors with decades of experience on Wall Street are caught up in the fraud.

His victim list wasn’t limited to the rich in America.  Madoff stole from some of the richest people in the world.  Europe, Asia, South America. Madoff had a reach around the globe.  He took billions from people who should have known better.

The saddest part… investors who lost everything.

The story of Thierry Magon de La Villehuchet is the most heartbreaking. Mr. Villehuchet ran a money management fund and was investing billions with Madoff.  His own personal fortune, some $50 million was heavily invested as well.  Villehuchet was personally vouching for Madoff.  He convinced his friends and family to invest.  He convinced clients and business associates.

Sadly, after the fraud was discovered Villehuchet took his own life.

Now, I’m not here to regurgitate the same news stories you’ve seen in the paper.

What I want to do is highlight a huge lesson everyone should learn from this mess.  Unfortunately it’s a lesson that’s been taught before and no doubt, will be taught again.  The lesson is simple.

It’s the importance of diversification.

We learned this lesson from Enron a few years back… don’t put all your money into one stock.  Now we’re seeing it again with Bernie Madoff.  The key here, don’t put all your money in one investment strategy.

The victims of the Madoff scam are feeling the sting of his fraud.  Some of them however will continue onward.  What was their secret?  They only invested a small percentage of their portfolio with the crook, maybe 2% to 5%.  These investors knew the importance of diversification.

More importantly, they practiced it.

The smart investors periodically rebalanced portfolios.  Cutting back on one position, adding to others.  Most importantly they spread their investments between strategies.  And inside those strategies they were diversified as well.

Other investors weren’t so smart.

They were being lured into the trap by easy money and big returns.  They went “all in” on the strategy.  Those are the investors who are absolutely crushed by this fraud.

Diversification’s important.  Not only across stocks, but across strategies as well.

What do I mean by that?

Simply this:  spread your portfolio between a number of different investments.  A big loss in one investment won’t wipe you out completely.  You’ll be able to weather a big loss… and live to fight another day.

Many investors focus on diversifying in stocks.  Erroneously they think holding a large number of securities is the key.  It’s a start, but not the perfect answer.  Diversification doesn’t help if you own all of the automotive stocks, and their suppliers.  An industry downturn is usually devastating for all stocks in the industry – even the strong companies.

I like to diversify across asset classes. Start with stocks.  Have a portion invested in small, midsize, and large cap companies.  Invest in U.S. stocks as well as high quality foreign stocks.  Then look to add other asset classes.  Tack on a bond fund or two, look at corporate, municipal, and government bonds.  Finally, add commodities, real estate, and even options to the mix.

Investors fortunate enough to hold big portfolios might even look to invest in hedge funds and private equity funds.

Every investor is different.  The percentage of your portfolio you should put into each asset class will depend on your specific risk tolerance, time horizon, and investment objectives.  Be sure to keep these in mind when reallocating your portfolio.

Right now is the perfect time to review your holdings and rebalance your portfolio.  It is the New Year after all.  Look at your portfolio and make the necessary adjustments now.  Start by evaluating your allocations between stocks, bonds, and cash.  Cut back on your largest holdings and start researching new asset classes.

Take the time to do this now.  It’s not hard to do, and it may save you from another Bernie Madoff (or Enron) down the road.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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