Is Your 401(k) Plan Diversified Enough?

It is no far stretch to say the biggest loser in the Bear Stearns (BSC) bankruptcy were its employees. One third of the company stock was/is held by Bear Stearns employees who’ve had a substantial amount of their life savings wiped out, as well as finding themselves out of job. Clearly, holding company stock results in a rather substantial exposure to idiosyncratic risk, the risk of their stock holdings being reduced to nothing, and the risk that they’ll be out of a job by tomorrow. Since you can’t exactly diversify your job, it’ll make sense to reduce the risk in one’s portfolio.

Unfortunately, that usually doesn’t happen. Participants in 401(k) plans offering employer stock invest on average about 33 percent in company stock. An introductory course in finance will tell you that that increases unsystemic risk, so why do most people expose themselves to such risk? Moreso the extremely smart bankers in Bear Stearns? (Although top management has obvious problems with risk management.)

Warren Buffet doesn’t believe in diversification. He’s quoted as saying “Wide diversification is only required when investors do not understand what they are doing.” Working day to day in a company probably provides not only the reassurance that the company won’t go bankrupt tomorrow, but that the company actually has decent prospects, and holding the stock might be a rather good idea. To hell with diversification, I know the company, I know what I’m doing and I’ll make a lot more money holding on to the stock.

Unfortunately, bad decisions are made by top management. And no matter how well employees might know and be able to influence the company, their effect is severely limited. They might be working for the company, but if half of your life savings are dependent on your top executives not screwing up, you’re still going to be exposed to an inordinate amount of unsystemic risk.

So like Enron before, Bear Stearns is a sad reminder that unless you’re smart enough to be the richest man in the world, it might be a very good idea to just diversify…