Why You Should Diversify!

Why You Should Diversify!
by Richard P. Halverson

The Fastest Way to Get Rich is to Bet Everything on One Stock. The Fastest Way to Get Poor is to Bet Everything on One Stock. The lessons of Enron: Often the stock you are betting on is the company you work for.

I have followed the human side of the Enron Corporation collapse with great sadness. Not everyone is familiar with the Enron story so here is a brief recap. Enron began as a company providing natural gas. A sleepy steady kind of company. In recent years it has evolved into much more. For example, it developed the world’s largest energy trading business. It was similar to a commodity exchange only without much regulation. It created a market place for those that wanted to buy or sell energy. Enron’s trading operation filled an important role in the nation’s energy production and usage markets. The company grew into one of the largest and most admired corporations in the world. Regrettably, along the way the management also invested heavily in some risky limited partnerships. From what I have seen disclosed thus far, these partnerships were not illegal. However, in an apparent effort to enhance the company’s financial statements the manner of accounting for these partnerships and the amount of apparent self-dealing with the management is somewhere between evasive and down right fraudulent. It took Wall Street a long time to catch on. It will take the lawyers even longer to litigate it. When investors did catch on there was an implosion of confidence in the company. That resulted in an implosion of the stock and bond values and led to Enron’s bankruptcy and thousand of employees who lost their jobs.

Enron’s stock was selling for over $90 a share fifteen months ago. Today it is selling for less than $1.00. In many ways the collapse of Enron’s stock is similar to the collapse of so many others that have characterized this particular investment cycle. Companies ranging from speculative Internet IPO’s to companies thought of as blue chips have seen their share prices plummet 70% to 90% and more. A lot of investors that bought at high prices are kicking themselves. But the saddest stories are often the employees. Many of these employees, some nearing retirement, had virtually everything tied up in the company stock. Their financial future has been wiped out with little time to rebuild. And thousands upon thousands have also lost their employment.

These days one of the most popular employee benefits offered by many companies is the 401k. Often these 401k plans involve company stock. Employees may be able to buy company stock as one of their investment options. Many companies match employee contributions with company stock, as did Enron. Almost by accident the employee will wind up holding more of one company’s stock in their retirement plan than they ever would choose to if they did not work for the company.

In addition to a 401k some companies offer other retirement benefit programs heavily invested in the company stock. Many companies also offer stock options and stock purchase programs for employees. It is easy for an ordinary employee to have nearly everything she has invested in the company she works for.

If you think that is lack of diversification consider that it is not just the employee’s investments that are tied to the company. The paycheck, the health benefits and Christmas bonus are also tied to the company. In a horrendous scenario like Enron’s the employee is out of a job, out of health benefits and watches his life savings drop 99% in 15 months. That is bad and it hasn’t been just Enron in this business cycle. Employees of many companies have suffered in a similar way.

Please don’t misunderstand: I am very much in favor 401k’s, stock options, stock purchase programs, salaries and Christmas bonuses. You should take full advantage of every benefit the company offers. These programs generally allow you to invest with company assistance and with tax advantages. Usually, these benefits are the most efficient means of wealth creation available to ordinary people. This country is full of retirees who are enjoying comfortable retirements because they took advantage of every option and every stock purchase program ever made available to them.

I am also very much in favor of these programs from the company’s point of view. Through them management hopes to give all employees a stake in the company’s success, develop incentive to work hard, reward people for their effort and increase morale.

Despite the fact that these benefits are intended to be good for the company and the employees it is wise for you to pay a lot of attention and seek to diversify where ever possible.

Diversification is a hallmark of responsible financial planning. It is a principle understood and practiced by wise investors all over the world. Diversification reduces risk (and potential reward.) It is also a technique that is subject to endless second-guessing. Two quick stories of diversification come to mind. I remember reviewing the account of a woman who had inherited $2 million dollars of company stock. The trustees properly decided to diversify by putting $1 million of the account in bonds. Many years later the value of the portfolio was worth about $201 million. The stock had gone up 200 times and the bonds had barely held their own. Diversification cost this woman $199 million dollars. However, there was another account. The numbers were different but the idea was the same, a large amount in a single stock and a decision to diversify by putting 50% in bonds. In the latter case the company went bankrupt. All that was left was the value of the bonds. Years later everyone could see what should have been done in both cases. But at the time there was no way to know.

Here are some considerations as you consider your personal diversification:

• What assets should you consider? Consider all of your assets, not just the value of company stock in your 401k and stock options. Include the equity in your home, for example. Also make allowance for fixed assets you may have such as a company pension plan that will pay regardless of the company’s fortunes.

• What level of diversification is needed? This is hard. Unfortunately you will not know until after the fact. That is why I told the two diversification stories above. If the stock is going up you should have everything in it. If it is going down you should have nothing in it. In the event you don’t know what is going to happen to your company stock, here are some things to think about:

• Experts generally like to see exposure to a single security at 10% or less in a broadly diversified portfolio.

• For companies with defined benefit pension plans the law will not allow the percentage of company stock to exceed 10%.

• You, however, are not an institutional portfolio governed by ERISA laws. You can have greater than 10% exposure to your company’s stock.

• Your attitude toward risk is important. If you are comfortable with investment risk, concentrate more. If you are uncomfortable with investment risk, diversify more.

• Your time horizon is important. If you need the money in the next several years for retirement or other purpose reduce your risk. If you have a long time horizon you can take more risk.

• Many 401k plans are designed to get employees into the company stock. In these cases make elections within the 401k to diversify when you can. Then use your non-401k investment money to buy something totally different than the company stock.

• Remember you have more than just your 401k money tied up with the company’s fortunes, you’ve also got your job tied up the company’s fortunes hold less.

• Remember it is your company, you should be invested in it hold more.

• I keep writing (with pen in cheek) that if the stock is going to go up you should own it. As an employee of the company you have an edge on making this judgement. You are an insider. (In this regard I do not mean an insider as defined by the SEC, someone with material inside information. If you are that kind of insider hopefully you know it and know that a whole different set of rules apply to your buying and selling. If you have any question consult an attorney. A mistake here can send you to jail.) But alert ordinary employees at all levels know a great deal about how their company is doing. They can feel morale. They can feel the pace of business. They can feel how their competitors are doing. Take advantage of these inside feelings. If you sense things are really on the upswing lean toward holding more. If you sense things are really on the downswing lean toward holding less.

After many years of working with people to invest their money I can make these observations. The easiest way to accumulate great wealth is to inherit it. If your ancestors didn’t do it for you then the next best way to accumulate wealth is through the company you work for. In most cases this turns out to be the family business, everything from the family farm to a small chain of dry cleaning stores. Most of the nation’s millionaires are individual entrepreneurs leading very middle class lives. For many others the best way to accumulate wealth is to go to work for a public company that is really going somewhere. Then do everything you can to help them get there and take advantage of every opportunity to invest in the stock. But along the way please think about your personal diversification.

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