What AIG Can Teach Investors About Diversification

Imagine that back in 2007, you had $3,000,000 to invest on behalf of a private family investment partnership you were running.  You decide to split this into three different companies.  One of these was AIG, the insurance conglomerate.

AIG shares fell from a high of $1,459.00 each to $6.60.  The Board of Directors had to do a 20-1 reverse stock split to keep the thing from trading for less than the value of bottle caps.  Even with the stock at $50.84 today and $36.03 in cash dividends you received over that time period (most of which came before the destruction of the common stock), the economic losses are catastrophic.  Your $1,000,000 now represents around $35,400 worth of stock and $25,000 in cash dividends that piled up in your brokerage account for a grand total of $60,400.

Take a moment to fully reflect on the gravity.  If you had invested $1,000,000 in the company seven years ago, you’ve patiently waited to find yourself sitting on only $60,400, a big part of which came from dividends.  Your losses were a staggering $939,600.  For every dollar you contributed, you’re left with a mere 6¢ despite the better part of a decade passing.  The odds are overwhelming that you will never make that money back with inflation adjustments because the AIG company is still as large as it was, with all the lumbering slowness of a behemoth, only there are exponentially more shares outstanding.  The stock could quadruple and you’d barely have made a dent in your losses.  That is the very definition of permanent capital impairment.

Here is the crazy part: That other $2,000,000 you invested?  If you earn perfectly average rates of return on your holdings for the next 25 years, you’d end the period with around $21,670,000, despite losing one-third of your initial capital straight out of the gate.  If you had one average holding, and one super-holding that turned out to be a winning lottery ticket, like Wal-Mart, you’d end up with $106,000,000.

That is the reason diversification matters.  Done correctly, it can increase your odds of good results in a very real way.  This is especially true when you realize that most of the time, the businesses that do fail won’t fail right away, so you get an Eastman Kodak effect where you might have years of spin-offs and dividends compounding for you outside of the initial investment itself.

Throwing all of your capital into a single company, no matter how successful it appears to be, is not an intelligent way to behave because, 1.) if you are right, you would have still grown richer if it were part of a reasonably diversified portfolio that did well in the aggregate over the measurement period and 2.) if you are wrong, you exponentially increase the chances that you lose everything.  It’s a terrible way to position your finances even if the probabilities are in your favor.  Unfortunately, it seems the 1 in 8 families who invest in stocks directly are doing just that by choosing to own shares of only a single enterprise or two, often in the employer of one of the spouses.

Update: For a related post on how diversification can increase returns under certain circumstances, read The Mathematics of Diversification and Wealth Building.