The collapse of Enron dominated the business news here in Houston and around the world. In fact, for some people I know, the Enron story was painfully personal.
In the years just prior to the company’s collapse, the company urged employees to keep all their retirement funds in Enron stock.
One of my clients realized that was a risk she wasn’t willing to take, but another client bought the company’s promises of long-term stability.
Beth came to me a few months after the company filed bankruptcy. For all intents and purposes, Enron had ceased to exist, but she had a huge amount of money to invest. I asked, “How did you get out of there with all this money?”
She replied, “I saw the writing on the wall, so I took my money out of Enron stock well before it tanked, and I put it in other funds.”
Today, Beth’s retirement account is doing quite well.
But Frank didn’t see the writing on the wall. He believed the officers who told him, “Don’t worry. Everything will be just fine.”
In the heyday of the company, Frank had over $1 million in Enron stock in his retirement account. A few months later, he had nothing.
The financial setback was too much for him. The pain and shame caused panic attacks, then a heart attack. Frank died as another casualty of Enron’s financial mismanagement.
Diversification is a way to spread risk so the problem Frank experienced doesn’t happen to you.
My favorite illustration comes from my friend David Coney at Edward Jones. David taught me to illustrate diversification by talking about elevators.
I tell the client she has a choice of two elevators. A single cable holds up one elevator, and eight strong cables hold the other. The building, I tell the client, is 100 years old.
Then I ask, “Which elevator would you take to the top floor?”
This question often elicits a chuckle and a quick reply, “The one with lots of cables.”
The single cable may be strong for a long time, but if and when it ever breaks, people in the elevator will be in trouble.
But if one of the eight cables on the other one breaks, the other cables can hold it very securely.
This simple drawing illustrates the difference between trusting in one financial product (that is, “putting all your eggs in one basket”) and having a diverse portfolio.
This illustration also describes the benefits of mutual funds, Index Funds, or ETFs over individual stocks. In a mutual fund, the managers check the cables (individual stocks) in their diversified holdings, and replace those that aren’t performing well or have too much risk.
It’s sound, established, financial logic to avoid having too many assets in a single investment, but some executives, managers, and employees view their company’s stock like it’s their first-born child.
For example, one man told me, “I’d never sell my company’s stock. I’d feel disloyal.” We talked further about the benefits of diversifying, and ultimately, logic prevailed. Some people, however, won’t budge. Their emotional investment in their pet stock is so strong that they simply can’t bring themselves to sell any portion of it.
