Every investor is familiar with the phrase, “invest in what you know.” Taking this advice leads to an undiversified portfolio with higher risks and lower returns. This psychological tendency is called familiarity bias, which must be avoided in order to become a diversified investor.
I’ve noticed that many people have a significant portion of their retirement savings devoted to their company’s 401(k) plan. Even though this is a wise way to save and invest, oftentimes, those savings are heavily invested within their company’s stock. This can have devastating effects if the company goes through hardships—or even worse—bankruptcy. In the event of bankruptcy, the employee loses a significant portion of his/her wealth—and in some cases—all of it. Consider the Enron bankruptcy in 2001. 60% of all assets within Enron’s 401(k) program consisted of Enron stock. For many employees, what took decades to build was completely wiped out in a matter of months. Putting all of your eggs into one basket is perhaps the riskiest thing you can do with your money. For the undiversified employees at Enron and countless other companies that have gone bankrupt, it cost them everything.
Investors are oftentimes unwilling to invest a significant portion of their assets in international stock. This is a common theme that has been well documented in the investment industry for decades, as many investors are more comfortable in domestic companies and funds. Investing in American funds alone does not lead to diversification or higher returns. From 2000-2010, the S&P 500 index returned a lousy 0.4% annually, while international asset classes ranged solidly from 2%-11.8% annually. Academic research has shown that holding a diversified portfolio comprised of both domestic and foreign funds will actually lead to higher returns while also incurring LOWER risk.
Investors should heed the warning of Benjamin Graham, who said, “The investor’s chief problem—even his worst enemy—is likely to be himself.”
