8. Don't confuse the familiar with the safe and end up having too many eggs in one basket.

For the 20-year period ending in 2006, Bear Stearns' stock outperformed Berkshire Hathaway's stock by an amazing 4.5 percent per annum. With returns like that, who needs Warren Buffett? And consider the following story that appeared in Barron's in 2004. The author noted that "with the company's low risk profile and strong controls, investors in Bear Stearns can sleep well, knowing that even a full-blown financial crisis is unlikely to cripple the firm."¹ In January 2007, the stock hit an all-time high of $171. We can only wonder how many employees of Bear Stearns had significant portions of their net worth tied up in company stock because they "knew" what a great company it was. And surely they would know if there were problems arising and have sufficient time to exit. It is safe to assume that those same employees would not have invested in Bear Stearns stocks if they were employed elsewhere. Bear Stearns was not any safer because the individuals happened to work there. Yet, employees seem to make that common error because they confuse the familiar with the safe. And for senior management, they may even have an illusion of the ability to control events. The prudent strategy is to diversify all of your assets. And that includes your labor capital, not just your financial assets. And while the surest way to get rich is to concentrate your assets, it is also the surest way to go broke. While investors who had concentrated positions in Bear Stearns suffered greatly, investors that owned market-like global portfolios had a small fraction of 1 percent of their assets in Bear Stearns stock, even when it traded at its peak. This is a clear demonstration of the importance of diversifying equity risks. Unfortunately, as sure as death and taxes, despite the lesson Bear Stearns provided, this same mistake will be repeated many times over by future investors.

Summary

While each crisis the markets face is in different in some way, those that follow the principles of prudent investing can minimize the risks of catastrophic losses. Those rules include:

• Avoiding taking more risk than one has the ability, willingness and need to take by ensuring that you have sufficient fixed-income assets.
• Limiting the fixed-income portion of the portfolio to the highest investment-grade securities.
• Ensuring that you maintain sufficient liquidity so that you are not forced to sell risky assets into an illiquid market.
• Avoiding confusing the familiar with the safe.
• Never mistaking the unlikely for the impossible and the likely for the certain.
• Avoiding having too many eggs in one basket, especially if that basket includes your labor capital.

The bottom line is that those investors that follow these rules, and build financial crisis into their plans by anticipating them, are far more likely to survive them in good shape.

¹ Andrew Bary, "How Sweet It Is," Barron's, August 2, 2004.

Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn't Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services - a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices - in Clayton, Missouri (www.bamservices.com).

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.

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