In my career as a financial adviser, I reviewed thousands of customer portfolios. After a while, I saw the same money-management mistakes time and time again. One of the most common money blunders was having too much money in a single investment -- the classic "putting all of your eggs in one basket" mistake.
It wasn't just beginning investors who got themselves into this dangerous financial situation. Even savvy, experienced clients did.
The names have been changed to protect people's privacy, but the scenarios below are very real. Here are four ways that people end up with wildly unbalanced portfolios, and how to avoid this classic investing pitfall in your own portfolio.
Gina: Tying her fortune to her employer's future
I like chocolate cake just as much as the next gal, but if I eat too much of it, I'm in for a huge stomachache. The same goes for owning too much company stock of an employer. I remember meeting Gina, an employee of a nearby Hershey (HSY) plant. As I reviewed her 401(k) statement, I found that Hershey stock represented more than half of her 401(k) balance. The tale of Enron serves as an example of how this can go horribly wrong. With that company's demise, employees not only lost their jobs, but also their futures -- all the plans they made for their post-9-to-5 lives -- because their retirement savings were invested mostly in Enron stock.
Dr. Crane: Mistaking industry knowledge for investing smarts
Dr. Crane, a surgeon, held vast industry knowledge that he felt gave him a leg up on other investors. So he put his money behind a company whose products he strongly believed in, loading up on the company's stock. (In this case, shares of Pfizer (PFE) dominated his portfolio holdings.) By doing so, his money was over-concentrated in a single industry -- health care -- which meant that when the industry suffered, his nest egg deteriorated along with it.
Jean: Avoiding Uncle Sam and getting overwhelmed by her blockbuster investments
Jean despised paying taxes. And when I first met her, she was excited to tell me about how she planned to avoid paying them by holding on to her winning stocks. I had to explain to Jean that this tactic threatened her potential overall portfolio returns. By not harvesting her gains and paying Uncle Sam his share, she increased her position in her winning stocks relative to her other investments. With time, Jean's unsold winners threatened to over-concentrate her portfolio.
Richard: Doubling down on a hot stock
One afternoon, Richard, a well-meaning investor on the verge of retirement, stopped by my office to tell me about a great investing opportunity he'd heard about from a co-worker. It was a company that had recently IPO'd. Richard recounted for me all of the claims that his co-worker had made about the stock. So impressed was he that logged into his online account, sold a huge portion of his diversified blue-chip stock portfolio, and doubled down on the hot stock tip. Here, again, the concentration in a single investment put his overall wealth at risk, especially if the IPO later fizzled out.
Don't become a cautionary tale
The most alarming thing about Gina, Dr. Crane, Jean, and Richard is, frankly, that there's nothing at all extraordinary about their stories. They managed their finances in a perfectly ordinary way, yet all of them put their portfolios in grave danger from a diversification standpoint.
- Limit any single stock position to no more than 5% of your overall net worth.
- Use caution when loading up on stock in an industry with which you are intimately familiar.
- Realize that, as difficult as it is, sometimes you need to sell your winners for the overall health of your portfolio.
- Don't let greed or excitement overwhelm rational thinking.
By doing these things you'll minimize risk and sleep better at night.
Motley Fool contributor Nicole Seghetti does not own shares in any of the companies mentioned above. However, in the spirit of full disclosure, she has fallen victim to one of the above pitfalls. Motley Fool newsletter services have recommended buying shares of Pfizer.