Un-diversification: Does it ever make sense to put your eggs in one basket?

And watch that basket.

As I don’t have a copy of Pudd’nhead Wilson, I don’t know the context. But Mark Twain once wrote that you should put all your eggs in one basket…and WATCH THAT BASKET.

You’re encouraged to diversify when you invest. A lot of employees sink more than half their 401(k) money into company stock—and then Enron show’s everyone why that was a bad idea. Even seemingly solid companies—banks, for example—can disappear overnight, but it’s much less likely that an entire index or basket of stocks will dramatically lose value.

Still, “watching the basket” is tempting. For one, it’s less to keep track of. If GE is one of five stocks you invest in, you’re going to know more about GE than you might about your own company. On the other hand, if GE is one of 20 stocks you own, you probably won’t know a heck of a lot about any of them.

But putting aside the benefits of focusing your knowledge, there are definite times when it doesn’t make sense to diversify, even if you planned to achieve it by buying one or two index funds. Here are a few of them.

The investment carries no risk.

The last few times I’ve touched on currencies and foreign bonds, I’ve had a few comments and e-mails asking about buying foreign government bonds. Even if the U.S. government up and disappeared, the argument goes, the government of, say, Australia would still be around to give your bond principal back.

It seems like this kind of argument comes from a general mistrust in the stability of the American government, which is pretty popular these days. Even China, one of the biggest foreign holders of Treasury bonds (with Japan), says it’s worried that the U.S. can’t sustain its debt levels.

But just because an investment isn’t as safe as it once was, doesn’t mean you should diversify away from it. Diversification only makes sense if adding the asset reduces your risk.

What can you add to Treasury bonds, FDIC-insured money market accounts, or CDs that would make your portfolio, as a whole, more safe? I can’t think of anything, and the solutions people have proposed carry their own, greater risks.

There’s nothing to show, for example, that holding foreign bonds of countries other than the U.S. would save you if the U.S. defaulted on its debt. In fact, the bonds of Australia, countries in the European Union, and Asia would probably be in big trouble as their own holdings of U.S. debt became worthless. What’s more, foreign bonds carry their own risks. Currency fluctuations happen constantly and could bring the bond’s value down at any time.

FDIC-insured products, like checking accounts, CDs, and money market accounts, fall into the same category, assuming you’re beneath the $250,000 FDIC limit for any one bank. Sure, the FDIC is underfunded. But that’s irrelevant. If the FDIC runs out of money, it’s going to be backed by the Treasury and Congress with every dime the U.S. government can mint.

Put simply, if you’re holding Treasury bonds to maturity or have money in FDIC-insured accounts, diversification gets you nothing. Just pick the account with the best combination of convenience and interest rates, and you’re done.

You need your money at a specific time.

If you’re like most investors, including me, you keep most, if not all, of the bond portion of your portfolio in bond mutual funds. That makes sense for those of us who are young to middle-aged. We’re saving for some obscure and far-off goal of retirement and don’t have an urgent need to get the money back.

But talk to someone a bit older, and you might find that they have most of their money in a bond ladder. of just ten or so bonds.

At first blush, you might think that’s really dumb. Instead of holding the vast universe of bonds included in something like the Vanguard Total Bond Market Index fund, they’re putting hundreds of thousands of dollars in the hands of just ten or so companies. Even though those companies might be seemingly strong, like GE or Anacott Steel, we all know that companies like GM and Ford once looked totally safe too, and look where that got us.

But the calculus of someone saving for a goal that’s soon to arrive is a bit different. You see, if you know you need a certain amount of money in exactly ten years, then a ten-year bond is a great way to get you there. A bond fund holds hundreds of bonds with different maturity dates. So its value is going to rise and fall with interest rates. You basically will never know with any certainty how much it’s going to be worth at any point in time.

On the other hand, an individual bond has an exact maturity date, and if you hold it until it matures, you don’t have to give a damn if interest rates double or halve while you hold it. As long as the company is still solvent, you’re going to get your money.

There are a couple caveats of course—the big one being that the company has to still be solvent. Companies can go through a lot over the course of a 10-year bond. Individual corporate bonds also only make sense for people with a lot of money to invest. Otherwise, you can end up paying a huge premium to what the bond would normally sell for.

But laddering Treasury bonds, and sometimes even municipal bonds, isn’t out of the reach for individual investors. For young people, it could make sense if you’re saving for a kid’s college expenses or a home downpayment. If you only have a little money to invest, you might forego the complexities of the bond market and just ladder CDs.

In the end, bond funds are great for diversifying you away from the risk a company will default, but do nothing to save you from interest rates rising (which make bond prices drop). And rising interest rates are a real, imminent threat to bonds right now.

Sometimes, you can’t diversify.

Ok, this doesn’t fit the topic as well, but let’s face it, sometimes you can’t diversify even though you want to. The classic example is your home. If you own an apartment in Manhattan, where the median home price is $900,000, you’ve probably got most of your wealth tied in one, 600-square-foot piece of real estate. The building or neighborhood could become unpopular. Wall Streeters could lose their jobs in droves again, tanking the local market. That’s not exactly what you call diversification.

Or the second, less classic, example: yourself. A 30-year old probably has more than $1 million-worth of earning power left in him, far eclipsing the $100,000 or so he or she’s saved already. But aside from taking on a second job, I can’t think of many ways he can protect himself from his industry failing or a debilitating injury with diversification. (He can protect himself with education or disability insurance.)

So diversify away, but only where it makes sense. And in the areas where you can’t—namely your home and your career—for the love of God, watch that basket.

Tagged as: bonds, Investing, stock market