The importance of diversification through the lens of collapsed banks

The recent collapse of First Republic Bank and Silicon Valley Bank are harsh reminders that any stock can fall to zero, regardless of how established a company. This is evidence of the importance of diversification which is a fundamental principle to investing. If your wealth is highly concentrated in any one individual stock then you’re gambling, not investing. And that’s fine, so long as you don’t mind losing what you bet.

In the case of First Republic Bank and Silicon Valley Bank, management took too much risk. However, investors do not have to and everyone who invests in the stock market should prioritise diversification in their portfolio.

First Republic Bank has been included as part of the S&P 500 index since 2018. On the day JP Morgan Chase announced that it was taking over the troubled bank, how did First Republic’s dissolution impact the S&P 500?* When the market closed, the index was down 0.039%**. 

Now do you see why diversification is important?

Diversification is the practice of spreading investments across a variety of assets. It’s a time-tested strategy to mitigate risk. Children learn about it early in life with the phrase “Don’t put all your eggs in one basket,” but all too often, grown-up investors forget.

I think it’s safe to assume that the total value of the stock market will not go to zero. However, the same cannot be said about any individual stock, no matter how promising the future of a company might seem. Why not? Because we cannot predict the future. The current price of any stock reflects the value of all its future income streams, but it’s no guarantee.

Can anyone predict which ones? Fortunately, there’s no need to. You can have a positive investment experience without knowing what’s going to happen with any individual stock because of diversification.

Now is the perfect time to engage a financial adviser. To find out more about how we set our clients up with diversified investment portfolios book a time with James Gray.

Footnotes:

*“First Republic Bank Is Seized, Sold to JPMorgan in Second-Largest U.S. Bank Failure,” Wall Street Journal, May 1, 2023.

**S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Decrease of 0.039% was on May 1, 2023.