Don't Put All Your Eggs in One Basket: The Secret to Safer Investing

 

        In the land of peace and harmony, there lived a farmer who planted his entire farmland with bananas. One day, a storm hit, and all his banana plants were destroyed. The farmer was devastated by the unfortunate event. All the effort and investment he made in planting bananas went in vain.

Learning from this experience, the next time he planted a portion of his farmland with bananas, another portion with root vegetables like potatoes, and the remaining land with pumpkins. Unfortunately, another big storm hit the farm, but this time only the banana plantation was affected. The root vegetables and pumpkins survived, and the farmer made a decent profit and stayed happy.

The same lesson should be applied to our investments. When we invest in any asset classes, we should not invest the entire amount in one particular asset class or sector.

Imagine if someone nearing retirement invested 100% of their money in the stock market, and the market faced a downturn for the next five years. There are times when one asset class performs poorly, and another performs well. We can never predict with 100% certainty which asset class will perform better in any given time. This is where asset allocation comes into play. Just like the farmer, we should diversify our investments across different asset classes rather than sticking to one. By doing so, we reduce the overall risk.

Let’s examine some drawbacks of each asset class:

Gold:

People often say gold is the safest asset class. However, on April 5, 1933, President Franklin D. Roosevelt signed Executive Order 6102, which made it illegal for U.S. citizens to own gold in the form of coins, bullion, and certificates. Some of the gold we may have purchased a decade ago, or inherited from our parents, might not have the BIS (Bureau of Indian Standards) hallmark. This raises questions about the purity of the gold and reduces its resale value.

Real Estate:

In the 2000s, many people bought homes using bank loans, which inflated the price of real estate. To curb inflation, the Federal Reserve raised interest rates, leading to higher monthly payments on loans. This resulted in defaults and foreclosures. As more homeowners defaulted, the supply of real estate properties increased, but the demand decreased, causing prices to fall.

Fixed Deposits / Bonds:

Twenty years ago, banks offered good interest rates, and inflation was low. Now, the interest rate is around 6.5%. If we factor in high taxes and inflation, the real rate of return on fixed deposits and bonds can turn negative, making it a poor-performing asset class in some cases.

Stocks:

The stock market has seen significant downturns in the past, including the 2000 Dot-com crash, the 2008 Global Financial Crisis, the 2020 COVID-19 pandemic, and the 2022 Russia-Ukraine war—the list goes on.

 

Conclusion:

Asset allocation is subjective and it must depend on each individual's risk appetite and financial needs. The strategies that work for one investor may not work for another.

It’s important to know how much risk you can handle and create an asset allocation plan based on that.

Now you know why Warren Buffett said, “Don’t put all your eggs in one basket.”