An expensive real-life lesson

In October of 2000, after working at the same company for more than 30 years, Charles Prestwood retired a millionaire. Not bad for a blue-collar field worker.

Admittedly, he had been somewhat lucky, spending his career with a company that became the seventh-largest in the United States. Fortune had named it “America’s Most Innovative Company” for six straight years. Charles was also a good saver, building his 401(k) account to nearly $1.3 million. It had done so well that when he left his job, he kept his retirement funds in the plan.

In December of 2001, a little more than a year after he retired, Mr. Prestwood’s former employer suddenly filed for bankruptcy. His 401(k) account was frozen. And by the time he was able to access his life’s savings, its value had dropped to just $8,000. At the urging of his employer, Charles Prestwood had invested nearly every dollar of his retirement in company stock.

The company was Enron.¹

Lest you think that Enron is a convenient, isolated example I’m using to make a point, think of the former employees of other companies who made the same mistake: Compaq Computers, Pan Am, Eastman Kodak, WorldCom, Circuit City, Bethlehem Steel, Woolworth’s, Blockbuster Video, Lehman Brothers.

In my retirement seminars I like to hand participants a pencil and ask them to snap it in half, which they are all able to do with ease. I’ll then pull out a bundle of 25 pencils taped together in a bundle and challenge anyone to repeat the feat. I’ve yet to have a taker.

I use this exercise to illustrate the power of diversification, an important investment principle designed to reduce the risk of putting too much of your savings into one company, one industry, one asset class. A lot of people fear that diversification, while reducing risk, will also lower their investment returns. But that’s not necessarily true.

Let me illustrate with an extreme hypothetical example involving someone with $50,000 who decides to divide his portfolio among five different investments for the next 20 years:²

• $10,000 goes into a coffee can buried in his back yard, where it will be “safe”.
  • Hypothetical annualized return: 0%

• $10,000 goes into a fund made up of fixed-income investments.
  • Hypothetical annualized return: +5%

• $10,000 goes into a fund made up of the stocks of large, established companies.
  • Hypothetical annualized return: +10%

• $10,000 goes into a fund made up aggressive-growth stocks.
  • Hypothetical annualized return: +15%

• $10,000 goes into a highly-speculative venture that winds up going out of business, costing him his entire investment.
  • Hypothetical annualized return: -100%

By most standards, we would have to consider our friend’s foray into investing to be less than successful. One-fifth of his portfolio was a total loss, gone forever. Another 20% chunk sat idle and earned nothing. The rest at least showed some positive returns.

Would it surprise you to learn that after 20 years, this hypothetical investor’s $50,000 would be worth $267,472 – more than five times his initial investment? That’s a compound return of 8.7% per year. Not so bad after all!

Despite making some very bad decisions on both ends of the risk/reward spectrum, the one thing this investor did correctly was diversifying his portfolio. By spreading his risk, he was able to achieve a pretty decent total return over time.

When markets are obsessed with a singular theme, such as dot-com stocks in the late 1990s or real estate in the mid-2000s, diversification can feel counter-productive, frustrating, even boring. If it’s excitement you seek with your investments, diversification will probably disappoint you.

But if your goal is earning reasonable investment returns without taking unnecessary risks, it’s a great place to start.

¹ “Enron Fall Turns Dreams to Dust”, Chicago Tribune, January 14, 2002.

² All of the investment returns in this illustration are hypothetical and do not represent an actual portfolio.

Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. This hypothetical report is not indicative of any security performance and is based on information believed reliable. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions.