It used to be that prudent investing always revolved around the principle of "diversification." Putting your money into different assets, you were told by your advisor, spread your risk around and prevent one stock, mutual fund, or asset class from dragging you down.
I always found this advice to be a bit naive. A few assets, carefully chosen and monitored, offers more risk but also more return. Statistically, once you own more than about 7 stocks you might as well own 30 or 50 because they cross correlate and essentially become an index. Ask Warren Buffett how he feels about diversification. Or better yet Bill Gates or Steve Jobs. Most of their wealth is tied up in one stock. The trick is knowing when to sell or protect your position. When Mark Cuban sold Broadcast.com to Yahoo he became a billionaire in Yahoo stock. However, Yahoo started to plunge in value. Cuban was astute enough to buy puts on his stock to protect his position, and while other owners of Yahoo saw their wealth evaporate in the tech wipeout of 2001, Cuban prospered. He was diversified into one stock, but he knew to monitor it himself and protect his position. I was at a soccer game the other day with employees of Wachovia who were shell shocked that their company stock cratered in a week. Why more investors don't use stop loss orders is a mystery to me.
In these days of ultra-low commissions it makes no sense not to sell when trouble appears, especially in non-taxable retirement accounts. Yet people will watch their accounts go down and do nothing, or listen to their advisor. Here's a news flash. If your financial advisor was any good, he wouldn't be a financial advisor. He'd be retired, having grown wealthy on his own advice. Ask yourself why he still schlepps to work every day. Financial advisors are product distributors, plain and simple. I heard from a friend yesterday of stockbrokers selling Lehman bonds, now worthless, to little old ladies as recently as a month ago. That's not advice, that's a firm unloading its inventory to protect itself. Investing is Darwinian, and should be treated as such.
Which brings me to the point of this post. Given the institutional failures and bank runs we've witnessed recently, diversification takes on a brand new meaning. AIG nearly went broke. Merrill Lynch nearly went broke. Lehman did go broke. Bear Stears did go broke. WaMu? Gone. Wachovia? Buh-bye. These days diversification also means diverifying amongst institutions, i.e., keeping your money in multiple places. Like stocks, institutions go down too. Having all your money with one brokerage firm or financial advisor is foolhardy, even if they are "diversifying" your investments. Invest with multiple institutions. As Prince said, "In this life, things are much harder than the afterworld. This life, you're on your own."