Protecting Your Retirement Fund From Blue Chip Blues
The Dow Jones Industrial Average has commonly been referred to as the blue chip index. This crisis, however, has crushed some of the bluest of the blue chips. Reflecting on the demise of these companies is a good reminder on the importance of diversification as a foundation for your financial security.
Let me give you a few names: AIG, General Motors, Citigroup, Bank of America and General Electric. As of September 2008, these companies were all members of the 30 companies that made up the Dow. Now AIG is but a shell of its former self, and GM looks to be headed down the same road.
If the US government hadn't bailed them out, the others might be toast as well. That's a shocking number of "blue chip" companies that collapsed in rapid succession.
When planning for your future, you need to recognize that every company is vulnerable. No matter how good its bu
siness looks or how great it has been in the past, its economic value can evaporate, even though its buildings are still standing.
Yet I still see many people who maintain highly concentrated positions in certain companies. It usually happens because they have developed a false sense of comfort about the company.
People rationalize their holdings by saying things like, "well, I work for the company", or "my brother in law is an executive there" or "my grandfather retired on this stock."
Modern financial markets are terribly complex, and at a certain level your familiarity with a company doesn't matter when it comes to managing risk. Heck, even the CEOs of these companies had no idea that they were on the verge of collapse. That's just the way it is.
To manage this inherent uncertainty, a good rule of thumb is to avoid having more than five percent of your net worth invested in any one company, and less is generally even better.
Here are some common areas where I see investors failing to diversify:
- Employer Stock. If you have lots of employer stock in your 401(k), consider selling some and investing in a broader portfolio of companies.
- Stock Options. If you have vested stock options, consider exercising some so that you don't have a high concentration of your wealth riding on the price of one stock.
- Inherited Stock. If you were lucky enough to inherit a large stock holding from a rich uncle, thank him for it and then diversify.
- Bonds. If you own lots of bonds from one company, consider selling some and buying bonds from many different high quality companies. You've got to spread around the safe money as well.
In fact, on Wednesday, I read an op-ed in the Wall Street Journal written by a Michigan retiree who stands to lose a substantial portion of his retirement savings because he owns General Motors bonds. I feel bad for this individual. But if he had owned bonds from lots of different companies, the GM decline would hurt, but it wouldn't threaten his basic financial security.
Bottom line: Every company in every industry is vulnerable. To protect your financial future, make sure you diversify. I can't say it any simpler than that.
As with all financial matters, consult your individual adviser before making any financial decisions.
Chip photo from Flickr, courtesy of Plutor, CC 2.0
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