One of the well-worn axioms of investing is diversification. We have all heard repeatedly that diversification is a great way to lower the risk of investing. In principal, it is true that if you “don’t put all your eggs in one basket,” you lower your risk. If you are invested in a number of different sectors in the stock market, it should lower the risk of investing in the stock market. If you are invested in real estate, stocks, bonds, commodities, a private business, and art (or other investible collectibles), then it should lower your overall risk. The theory is rather straightforward: “One of those investments may go down, but they won’t all go down at the same time.” This theory has even more merit when it is restated as, “One of those investments may become worthless, but they won’t all become worthless, at least not at the same time.”
That said, there are two basic problems with this axiom and the theories behind it:
- When there is a large correction or panic in the stock market, almost all stocks go down. Some go down more than others, but in 2008 and early 2009 it was difficult to find any stocks that hadn’t gone down significantly. It was a great buying opportunity if you had cash or access to cash, but we will save that for another article. The point is diversification in the stock market only goes so far in limiting your investing risk.
- When there is a large correction or panic in the stock market, almost all other assets go down in value as well. Large corrections or panics are most often created by excesses in the economy and markets, followed by the realization that the economy isn’t as strong and the markets aren’t as bulletproof as once believed. As a result, as the stock market tumbles, investors throughout the economy have less money to invest in almost everything. Hence, the value of real estate falls, as does commodities, as does art and other collectibles. So, while theoretically diversification lowers your risk, it doesn’t eliminate it.
Throughout my life I have had the blessing of getting to know thousands of individuals who created millions, sometimes billions, of wealth for themselves. Almost all of them started with nothing. There are several things they all had in common, but one of the most basic was that they did not diversify. They worked tirelessly to protect and increase the value of one “basket.” Sure, after they had built wealth, they diversified into other investments, but to create wealth they focused on one thing, one basket. They bought one truck and started a global transportation company. They bought one deep fryer and started one of the world’s largest fast food chains. They bought one lathe and started an international manufacturing conglomerate. They bought a duplex and started a real estate empire.
Take an inventory of your life and what you are investing in. Pick the one thing that you have the most belief in, the most passion about, and plow yourself, your money, and your talent into that investment. Focus is how wealth is created. Diversification helps you protect that wealth once created, but more often than not, wealth is created by putting all your eggs in one basket and then watching that basket very carefully.