There’s a joke going around Wall Street trading desks that goes like this:
Trader #1: Did you know there are two sides to a hedge fund’s balance sheet?
Trader #2: Sure, the left and the right.
Trader #1: Yeah, but on the left side there’s nothing right, and on the right side there’s nothing left.
With fund manager-gone bad Bernard Madoff in the news this week, the joke, which I bet has been around a while, really hits home.
Madoff’s hedge fund, which for years had produced consistent double-digit returns, collapsed this month under the weight of its own hubris, bringing a “who’s-who” of elite American individuals and institutions down with it.
Hey, even billionaires are not immune to common money mistakes. But a toxic brew of greed and financial negligence took down some pretty big fish, including The Royal Bank of Scotland, Nomura Holdings, Steven Spielberg’s Wunderkinder Foundation and The Palm Beach Country Club, among others.
They should have known better, but Madoff’s investors lost way more than they should. Why? Because they failed to stick to one of the most important rules in investing – they did not diversify their money. Like the Enron employees who lost their life savings a few years back, plowing all their assets into the failing energy giant, the lesson is the same. Whether you've got $10 million in a hedge fund, or $10,000 in a 401(k), reducing the risk of catastrophe is only a matter of spreading your assets around.
Sure, other factors came into play to spoil the Madoff party. Lack of transparency, lack of accurate, solid financial statements form third-party auditors, and a questionable custody arrangement that had Madoff providing its own paperwork as proof of trades, all fed the beast. But those are oversight problems and the average investors likely wouldn’t know enough to look. But even the most novice investors has to know enough not to keep all of his or her money in one place.
That’s why you have to spread the risk, or “diversify” your investments. Spreading your risk is something you have to do when building your own investment portfolio. And the best way to reduce risk in an investment portfolio is by diversifying the types of investments you own, and by using different investment managers. Something that really shocked me in the Madoff case was that his investors had 100% of their money with one manager. That’s a huge mistake in my book. A little bit of risk management could have avoided that tsunami.
Diversification simply means dividing your investments up into more than one uniform category. It’s a great way to protect your money from the volatility of the economy and the financial markets. By diversifying your investments, you’re taking away the risk that one investment that’s gone sour – like Madoff’s -- will poison the rest of your portfolio.
Take a look at these diversification tips:
• Never put more than 25% of your investment money in one stock, or one fund, no matter how good the returns. This is a big issue with me because, after you look at the facts, diversification is the only free lunch in this game.
• Do your homework and don’t always rely on mutual funds. Actually, I never want you to be in a mutual fund (although I like index funds) because I want you spending one hour per week, per investment position, on stocks. With that schedule it’s hard to focus on more than five stocks. So I am uncomfortable for average investors owning more than 10 stocks, because that’s a ton of homework. As I said, I do favor index funds if you can’t spend the time needed researching stocks. If you want to pick among the fund managers I like, and spent months researching in Stay Mad, and that do well in bad times, check it out here. But again, don’t put all of your money in the hands of just one manager. One last point here. If you want to build your own stock portfolio, why not choose among the stocks I have handpicked in ActionAlertsPlus.com, the charitable trust I talk about so much on Mad Money.
• Make sure you include foreign stocks and funds in your portfolio.
• Stay disciplined about asset classes: spread your money around several categories
• Above all, learn from the Madoff mess. Do your research. Spread your money around. The risk of not doing so is the biggest risk of all.
A Closer Look at Diversification
To show you how diversification works to your advantage, let’s use an example:
A. A $100,000 investment with a guaranteed fixed rate of return of 8% will grow to $684,850 after 25 years.
B. The same $100,000 could be evenly diversified between five separate investments each with a different degree of risk.
The net result? A portfolio value of $962,800 after 25 years, or $277,950 more than the guaranteed investment. Why? Because three of the five investments performed below example I used in Example “A”. But the diversification into other assets that out-performed the scenario in Example “A” provided a greater long- term total return.