Common Investment Mistakes: Under-Diversification
We are halfway through a blog mini-series that dives into the more common investment mistakes I see people make. In this edition, the mistake spotlight is on Under-Diversification.
In my opinion, this is one of the most dangerous mistakes because, when taken to the extreme, it has the potential to cause an investor to lose their entire investment portfolio overnight. Under-diversification happens most often in one of two ways, both of which are due to falling in love with a particular stock. Keep in mind, when you fall in love with a stock, you often find that it does not love you back.
The Dangers of Falling in Love with a Single Stock
The most common way under-diversification takes place is when someone works for a relatively large employer with benefit options. Employees may be able to purchase company stock at a discounted price, participate in a tax deferred retirement plan, and/or have after-tax benefits like a Roth IRA. The employee feels dedicated and loyal to their company and may end up with much of their investment portfolio in that one company stock because they feel they know the company and its future potential.
Many Enron employees felt this way. They had no clue, due to it being the seventh largest corporation in the world at the time, that upper management was cooking the books. The failure of Enron also took Arthur Anderson down with it, along with all their employees. Another example is when Merck, the bluest of the blue chips, had their share price drop 70% in 3 months after the Vioxx lawsuits in 2004. It took many years for their shares to recover.
Privately held companies, not publicly traded, can be even more attractive to employees because of the feeling of having some inside view of the company. These stocks are much riskier. There is no market for their shares. The only redemption source for these shares is the company itself. If trouble sets in and there are not enough funds available for redemptions, shares will not be able to be sold.
The other common way under-diversification happens is simply when an investor is emotionally attached to a stock because it was inherited by a trusted loved one. Sentimentality can often be blinding and allow one company to inhabit much too large a percentage of the portfolio.
The Consequences of Under-Diversification
The point I want to emphasize is that with under-diversification, it is possible the entire investment portfolio could go to zero at any moment. I believe the added risk is not worth the possible additional returns that could be received by investing in one company. Instead, owning a beautifully diversified portfolio of 500 of the largest, most profitable, best financed, and most innovative companies in America, which historically have never had a 20-year period of negative returns, is the best way to safeguard your capital.
Comprehensive Financial Planning as a Solution
Under-diversification is just one mistake in an investment portfolio that could be solved by a comprehensive financial plan. A thorough plan will define the return you need to reach your goals. The plan will also help you stick with the portfolio by encouraging correct behavior throughout a lifetime of all the fads and fears of investing. Your investment portfolio should be considered a tool for the accomplishment of your goals as opposed to an end in and of itself.
Take Control of Your Financial Future
Ready to safeguard your investments and work towards a secure financial future? Contact us at WealthPlan Advisors Group to create a financial plan that fits your unique needs and goals. Let's build a strategy that moves beyond the common pitfalls of investing. Don't wait until it's too late. Protect your financial legacy by diversifying wisely and planning strategically with our team today.
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A diversified portfolio does not assure a profit or protect against loss in a declining market. Past performance is not an indication or guarantee of future results.