Welcome to the Blue Money Report

Note from the Editor:Contributing Columnist Larry Swedroe offers this series, broken down into two parts, on the risks of investing without diversification. Larry is the author of "What Wall Street Doesn't Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," and " The Successful Investor Today: 14 Simple Truths You Must Know When You Invest." Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Part One
Every investor knows that putting too many eggs in one basket is a risky investment decision that can easily be avoided by building a diversified portfolio. Yet many executives and long-term corporate employees end up with a very substantial portion of their assets in the stock of the company for which they work. I have seen numerous cases where employees have as much as eighty or even ninety percent of their investable net worth in their employer's stock. While individual stocks offer the possibility of both market-beating returns they also create the possibility of disastrous results as well. The risk of complete loss of investment is highest when holding an individual stock, but is significantly minimized when holding a diversified equity portfolio. Typically, an unusually large holding is the result of stock options and savings plans that encourage ownership of corporate stock. My experience has been that in the vast majority of cases, no actual decision was made to hold such a risky portfolio. The person just ended up with the portfolio without thinking about the risks incurred. In addition, in many cases people believe that because they work for the company they know just how good an investment they have. Let's examine why holding such an undiversified portfolio is really a poor decision, no matter how good the prospects for the company appear to be (remember that even the highly likely is not certain). In fact, if an investor takes the time to think about the decision in a rational manner, he/she would in all likelihood never retain the vast majority of his/her assets in his/her own company's (or any other company's) stock.

Whenever I meet with a client who has a large percentage of her assets in her own company's stock, I ask her to put herself in the following situation. She is the single greatest blackjack player in the world, never making a mistake counting cards. A casino has offered her a challenge match in which only one deck of cards will be used. On any individual hand she can bet any amount she likes, from 1 cent to her entire net worth, let's say $2 million. She can also quit the game at any time. She accepts the challenge and proceeds to bet 1 cent on every hand. Finally, the perfect situation arises: The dealer is down to only four cards left, all of them kings. The dealer can only deal three cards (because the last one is faceup) and then must shuffle and deal himself one more card. The client is then left with the following situation. She will have twenty points and the dealer will have ten, with one more card to be dealt. With only forty-nine cards remaining, the client will have:

• A 12.5% chance to lose (the four aces and other combinations which add to twenty-one).
• A 30% chance to tie.
• A 57.5% chance of winning.

In all likelihood, this will be the best bet (investment) the client will ever have a chance to make. The odds of winning are 4.6 times (57.5/12.5) greater than the odds of losing, and there is only a one in eight chance of losing. Now, with her spouse looking over her shoulder, I ask: How much of your $2 million net worth would you bet? Very rarely does the answer even approach ten percent of the client's net worth. Most people say something like $5,000 or $10,000. I then ask if she believes that the odds that her company's stock will outperform the market are as good as that blackjack bet. Most will admit that it is not.

What do we learn from the blackjack example? We learn that when the cost of losing (being wrong) is high, people become risk averse. Even with the odds greatly in their favor, they avoid risk. Examples of this prudent behavior are the purchase of homeowner's or life insurance. No one expects either to have their home destroyed or to die in the near future, yet virtually everyone buys insurance because the cost of being wrong is so high. Again, when the cost of losing is high, investors become risk averse. They do so because although it is highly unlikely that if they went uninsured they would suffer a loss, it is not impossible.

We can apply the blackjack lesson to the example of investors with the vast majority of their assets in the equity of their employer. First, investors who are also employees are actually making a double bet. If the company does poorly, it may lay off staff to reduce costs, putting their jobs in danger at the same time their investments may come under pressure. On the other hand, if the company does well, their income is likely to benefit from continued employment in a successful company.

Second, there is really no logical reason for investors to believe that their employer's stock will outperform similar stocks. Living in St. Louis I have found that executives of Ralston Purina often hold as much as 70 to 80 percent of their investable net worth in their employers stock. They are not only certain it will do well, but highly certain it will outperform the market. Of course executives of Monsanto have similar concentrated positions and they too are highly confident about the prospects for their company, and also highly certain it will outperform the market. And the same is true of executives of CitiGroup, and Anheuser Busch, and pretty much every executive I meet. Unfortunately, this is not Lake Wobegone where every stock is above average.

Obviously, by definition, not all investors' stocks can outperform the average. Some will do better and some will do worse. However, since investors are risk averse when they might lose a large amount, it doesn't appear to be rational to hold a large percentage of one's assets in one stock, especially when higher returns should not expected. Since executives at Ralston really have no logical reason to believe their stock will outperform that of Anheuser Busch (and vice versa), they are each taking what economists call uncompensated risk, risk that can be diversified away without reducing expected returns.

Think of it this way: Would the executive holding 70 percent of her assets in Ralston Purina be likely to own the same amount (or any) of Ralston stock if she did not work there? Of course not! And is it any safer to own Ralston stock if you are an employee of Ralston than it is if you are an employee of Monsanto (and vice versa)? Of course not! So why do employees/investors make this very common error? It is because they make the mistake of confusing the familiar (their company) with the safe. Being familiar with a company or stock does not make it any safer an investment. Consider the following. Residents of Georgia own a disproportionate share of Coca-Cola. Yet Coca-Cola is not a safer investment for a resident of Georgia than it is for a resident of Minnesota. Coca-Cola's headquarters just happen to be in Georgia. Investors therefore feel more comfortable owning it, because they are very familiar with it, than they are with owning say Kodak. However, residents of Rochester, New York, the headquarters of Kodak, feel more comfortable owning Kodak- each confusing the familiar with the safe.

Even if it were logical to believe that an investor would get higher returns owning the stock of their employer, are the odds as good as they are in the blackjack example? If investors wouldn't bet a large amount at the blackjack table with odds as stacked in their favor as they are in that hypothetical example, why should they make a large bet when the odds are far less favorable? Unlike the insurance decision, where investors treat the unlikely as possible, when it comes to the equity of their employer they seem to treat the unlikely-a sharp drop in their company's stock-as impossible. Many employees of such once high flyers as Enron and MCI have watched the vast majority of their net worth evaporate because they made the mistakes of confusing the familiar with the safe and treating the highly unlikely as impossible.

Some good examples of great companies that ended up providing investors with very poor returns follow.

• Black & Decker: The shares of the "do-it-yourself" toolmaker had risen 500-fold in fifteen years: The 1972 peak was not revisited until 1998.
• Campbell Soup: The 1961 price was not regained until 1982, twenty-one years later.
• Digital Equipment: The shares of this minicomputer maker, which had skyrocketed 1,000-fold from 1967 to 1987, lost eighty-five percent of their value over the next five years.
• Polaroid: The stock price in 1998 was only a third of its price thirty years earlier.
• PG&E: This California utility, a safe "widows and orphans" stock, declared bankruptcy in the first quarter of 2001 as a result of the California energy crisis.
• Xerox: The Cisco or Microsoft of its era was in danger of bankruptcy as we entered 2001.

The same logic about concentrating assets in a single stock applies if the individual is not an employee of the company in which he/she is invested. There are only two small advantages of owning a single stock. First, the cost of ownership is slightly less as there is no mutual fund with operating expenses and other costs that would be incurred (e.g., trading costs). However, the cost of owning a well-diversified, passively managed fund, or portfolio of funds, can be as low as 0.1 to 0.5 percent. Second, owning a single stock might be a bit more tax efficient than a portfolio of tax-efficient funds. Offsetting these small advantages are the very high risks incurred.

Equity investors face several types of risk. First, there is the idiosyncratic risk of investing in stocks. Second, various asset classes carry different levels of risks. Large-cap stocks are less risky than small-cap stocks and glamour (growth) stocks are less risky than distressed (value) stocks. These first two risks cannot be diversified away. Thus investors must be compensated for taking them. The compensation is in the form of higher expected returns (a risk premium). The third type of equity risk is the risk of the individual company. The risks of individual stock ownership can easily be diversified away by owning passive asset class/index funds or ETFs (exchange traded funds) that basically own all the stocks in an entire asset class/index. The market does not reward an investor with an extra return for holding one stock because that person could get exposure to similar stocks by holding a diversified fund/portfolio. Since the risks of owning a single stock (or a small number of stocks) can be diversified away, investors are not compensated by the market for taking that type of risk. This is why the ownership of the stock of a single company has more in common with speculating than investing. Investing means taking compensated risk. Speculating is taking uncompensated risk, like buying a lottery ticket.

The benefits of diversification are obvious and well known. Diversification eliminates the risk of underperformance. It also reduces the volatility and dispersion of returns without reducing expected returns; thus a diversified portfolio is considered to be more efficient than a concentrated portfolio.

Unfortunately, most investors do not really appreciate just how risky owning one stock, or even a small group of stocks, can be. Consider the following: We examined just how risky even the "safe" stocks of the S&P 500 are. Of the 500 companies in the S&P 500 as of October 1, 1990, only 302 (or 60.4 percent) were even still in existence ten years later (some of course were merged out of existence). Of the 302 (which certainly includes survivorship bias; many companies that did not survive in all likelihood produced very poor returns), only 79 (26.2 percent) beat the Vanguard S&P 500 index fund. Perhaps even more surprising is that seventy-five stocks (24.8 percent) returned less than riskless one-year treasury bills. Forty-five stocks (14.9 percent) managed to return less than inflation, as measured by the CPI. And, perhaps most important from a risk management perspective, thirty-two stocks, or 10.6 percent, had negative returns. Stocks are risky, and diversification reduces risk.

Perhaps another reason (besides overconfidence) for investors putting too many eggs in one basket is that they believe stock returns are normally distributed-the distribution of returns look like a bell curve with the median and the mean return being the same (half the stocks have above average returns and half below average returns). Given the apparent 50:50 bet, combined with overconfidence caused by confusing the familiar with the safe, they are willing to accept the risk of concentrated positions. Unfortunately stock returns are not normally distributed. There are more losers (below average returns) than winners (above average returns). This makes single stock ownership a loser's game (more losers than winners). It is easy to understand why this is so. While the maximum loss on any one stock is 100 percent, the potential percentage gain is virtually unlimited. Thus a few "Microsofts" provide high enough returns to offset the far greater number of stocks that underperform. Unfortunately, every one thinks they own the next Microsoft, and certainly not the next Enron (just ask any ex-Enron employee).

It has been my experience that once people take the blackjack test, they become aware, for the first time, just how risky a decision they have made. If you own any individual stocks you should ask yourself: If I currently didn't own any of this particular stock, and I did not work for the company, how much would I buy? And remember, if the answer is less than you currently hold, every day you own the stock, you are effectively buying that amount of stock-because, of course, you don't have to own it.