How to properly diversify your financial holdings
J. Paul Getty, founder of Getty Oil (and creator of the Getty fortune) once made an interesting observation about the difference between making and retaining money. He said that if you're interested in holding onto money, you put your eggs into many baskets. But if you want to make money, you go and get more eggs, put them all into one basket, and then sit on that basket and watch your eggs very closely.
Consider the great family fortunes made around late 1900s. The Mellons, the Carnegies, the Rockefellers, the Kennedys, and other families became wealthy because each was actively involved in and running one business -- whether that enterprise was steel, railroads, oil, or liquor. They gathered their eggs into one basket, so to speak, and focused pretty exclusively on that basket. (Sam Walton, founder of Walmart, is a contemporary example of that phenomenon.)
But look what happened in succeeding generations, when those rich business owners became more concerned with holding onto their wealth and passing it down to their heirs. The families started branching out into other investment areas, spreading out their fortunes into lots of different baskets. Today the holdings of these families are highly, highly diversified.
Stick with diversification
You're probably thinking, "I'd like to get rich, so why shouldn't I use the one basket approach? I'll put everything I have into that one stock or that one company that I just know is going to do well." The trouble is we really don't know which company is going to do well.
Also, you're forgetting the second part of Getty's observation -- the part about watching the eggs. To create wealth through a single company or a single investment, you have to be actively involved in running that company or that investment. That means hands-on, day-to-day involvement, in a position where -- theoretically at least -- you have a good idea of what's going on and have some control over what happens. Do you think the original Getty or the original Rockefeller accumulated their wealth by letting managers and underlings make the big decisions when it came to how their companies were run? Even with this level of involvement and control there is still a significant level of uncertainty. (You can't control everything!)
Some people can take that approach. It's not uncommon, for example, for small business owners to have up to 90 percent of their wealth tied up in their businesses. They make a decision to grow their business, to reinvest their earnings in technology and in people so that their businesses continue to grow. They're trading current income for future value. Farmers, for example, quite literally plow their profits back into their land. While their incomes may be at or below the poverty level, their net worth can be quite impressive because they have tremendous assets in land and in heavy equipment.
As a physician, however, you probably don't have the luxury to sit on a single investment, to watch it in the way that it needs to be watched. You already have too many demands on your time. So for very practical reasons you become a more passive and more diversified investor, and you should build your wealth in a more conservative way.
(I'm sure that you know of at least one person who took a chance on a fledgling company and is now reaping big bucks as a result. What you don't hear about, however, are the 99 other people who took similar risks and ended up losing everything.)
Dividing the eggs
You can begin to build wealth by living within your means, saving a portion of your money, and investing it on a regular basis to build a diversified investment portfolio. Diversification is where those multiple baskets come in.
People talk about diversification without really understanding what it means. Diversification is not merely a collection of investments; merely being invested in different stocks or stock funds does not by itself mean you're diversified. You can own numerous assets yet still not be diversified, because diversification is about owning the right combination of investments.
Start the diversification process with asset allocation -- dividing your money among different major classes of investments (the most common classes are stocks, bonds, and cash, but there are others). The percent of your portfolio that you allocate to each class goes a long way toward determining your investment return and volatility.
Next, you'll identify the specific investments that you will hold.
Diversification is what separates the amateurs from the pros because it is where the difficult job of selecting and monitoring the specific holdings takes place. One reason many portfolios are not adequately diversified is that this process entails a lot of work, not to mention the ongoing need to monitor and rebalance your holdings.
Diversification should be the mantra for people who don't have the time or interest to accept the risk associated with concentration. It should be the mantra for those who can't afford to lose their money (and who can?). Diversification levels out the peaks and valleys of being in the market.
Understand, however, that diversification can't completely protect you from the market's volatility. People sometimes think, "If I'm adequately diversified, bad things won't happen to me; my portfolio will not decline in value." That's not the case. You're still in the market, and still subject to its risks.
Some investors also believe that the more you diversify, the better your portfolio is. In fact, there are limits to the level of diversification you should have in your portfolio. Diversification is a great example of where more is not necessarily better.
The way you allocate and diversify depends on a lot of variables, including the returns you're looking for, your age, current financial situation, and your tolerance for taking risks. This is not an exact science and there is no one right answer, nor any one-size-fits-all portfolio. Be wary of any investment advisor who tells you that because of your age you should be invested 54.3 percent in small cap stocks, for example.
To successfully diversify, you have to be a conscious investor. That means knowing what you're investing in and why; understanding how much of your investment you can stand to lose; setting a goal and formulating a plan to reach it; and reviewing that plan at least annually.
Having a plan -- and paying attention to it -- can help you avoid some of the dangerous temptations that you'll face as an investor, including:
Is there ever a time when it's appropriate to put all your eggs into one basket -- to invest all your money into one stock in the hopes of making that big market kill?
There may be two scenarios in which that's appropriate. If you've decided that your goal is to be the Babe Ruth of investing, that you want to hit the home runs, then go for it. Just remember, when you set that goal, that you're going to get a lot more strikeouts than the less spectacular hitter who's willing to settle for the base hits. Make a conscious decision -- preferably with a financial planner, who can help you retain some objectivity -- to live with that risk.
If you're a gambler by nature, you may want to include in your investment plan some "play money" that will allow you to go for the big ones. Set aside as much as 10 percent of the money you have to invest put it in high-risk stocks. That way you're not risking your home, your retirement, or your children's college education.
That's the beauty of conscious investing -- being aware of who you are, what you own, how you own it, and what you want to do. Even if you can't be actively involved in running a company, you can take ownership of how you invest. You can decide which -- and how many -- of those baskets you'll choose for your own nest eggs.
Trevor C. Lewis can be reached at firstname.lastname@example.org.
This article originally appeared in the November/December 2003 issue of Physicians Practice.