From Nest Egg To Omelet: How Common Wisdom Failed Investors

By Douglas Rice | June 23, 2009 AAA
From Nest Egg To Omelet: How Common Wisdom Failed Investors

Don't put all your eggs in one basket. Just about everyone has heard this trite piece of investing advice.
This phrase refers to the need to diversify investments, and even the most novice investor has been told to diversify his or her portfolio to reduce risk. Many take this to mean that they should buy many different stocks or use mutual funds. Unfortunately, that interpretation of diversification didn't help investors very much in the recent downturn. All stocks fell substantially, and those who thought they had less risky portfolios due to diversification often lost just as much as those who hadn't diversified at all.

What gives? The painful lesson is that all stocks are eggs and the stock market as a whole represents a basket. Doesn't sound very diversified, does it?

About Eggs and Nests
To be more technical about it, the key to understanding why nearly everyone lost money in this market downturn - whether diversified or not - is found in the difference between systematic risk and unsystematic risk. Systematic risk is the risk that the entire asset class will move together. This can't be avoided. Unsystematic risk is the risk that one stock will move independently of all others, either good or bad. This can be avoided by owning several different stocks. (To learn more, read Risk and Diversification: Different Types Of Risk.)

So how can you protect your portfolio from both types of risk? Here are three tips that will help make your portfolio truly diversified.

  1. Don't Be Bound by Class
    Decide on the best asset allocation for you. In doing so, you should consider at least three different asset classes - stocks, bonds and cash - when developing your overall portfolio. When making this decision, recognize that stocks have the highest potential return, but also will lose the most in a downturn. Bonds are less risky, but also provide a lower return. Cash, such as a savings account, is the least risky, but provides very little return. Many investors, even after considering this, will opt for mostly stocks as they need or want that potentially higher return. But even if you end up with an all-stock portfolio, the process of consideration will help you realize that all of your eggs are in one basket and that you had better handle it carefully.

  2. Think Outside the Basket
    If you want the higher return of stocks, but still want some diversification, consider more advanced types of investments. These could include commodities, real estate investment trusts (REIT's) and foreign currencies. These are more complicated and maybe more risky. While not for novice investors, they are an option that can provide the potential for higher returns and the diversification away from that one basket of stocks.

  3. Focus on the Big Picture.
    As advanced investments are probably beyond most average investors, and the only way to have the potential for higher returns is to put a fairly high percentage of your portfolio in stocks, the only thing that will help is to watch that basket. This means you need to stay focused on the big picture and attuned to the overall situation with the market and the economy. Then try to adjust your portfolio when times start to look gloomy. This is very difficult to do, but it's the best chance you have to avoid losses when the entire market falls.

Most people want what they can't have: low risk and high reward. This makes deciding where to put your "eggs" very difficult. Just remember that buying more stocks won't necessarily reduce your risk. "Don't put all your eggs in one basket" is still a sound piece of investment advice - the problem is, many people who believe they're creating a diversified portfolio are really just collecting the ingredients for a larger omelet.

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