In our last post, we discussed the importance and benefits of portfolio diversification. A recent Wall Street Journal article (June 1, 2009) highlighted a number of individuals who have been affected by the GM bankruptcy.

A mechanic in southern California sold his small repair shop four years ago in preparation for retirement. He then moved to Kingston, Tennessee where he bought a small house on a lake for $ 70,000 – “nothing fancy”, he said. His one luxury was a new Corvette. He put the remainder of his money in GM bonds, all $800,000 of it. He thought he was making a safe investment because he was avoiding stocks. At the time, he thought GM was a solid company. When the bonds dropped significantly in value, he made a common mistake – he bought some more bonds.

With the bond holders due to get only 10% of GM’s remaining value, the mechanic’s retirement is in serious jeopardy. All too often investors place too much of their portfolio in one investment, in one asset class or with one advisor.

Other recent examples of poor diversification include the clients of Bernard Madoff who ran the biggest Ponzi scheme of all time. Madoff made a name for himself on Wall Street and gave millions to charities in an effort to gain investors’ confidence. He played “hard to get” so that investors had to know someone close to him in order to invest their money with him. Well-heeled investors, who should have known better, placed nearly all of their capital with Madoff, hoping to make a killing.

At the same time in Sarasota, Florida, Art Nadel, a hedge fund manager was doing the same thing as Madoff. Nadel’s scheme was on a much smaller scale – only $400 million! Like Madoff, Nadel was well known for his charitable contributions, including huge gifts to the local YMCA foundation, but with the stipulation that all the YMCA gifts be invested in Nadel’s funds. As with Madoff, numerous investors were wiped out because they placed too high a percentage of their portfolio with one investment manager, Art Nadel. Other Ponzi schemes have recently surfaced with similar modes of operation and similar results.

As we noted in our previous posts, diversification is crucial to investment success. It helps increase investment returns and reduces volatility. More importantly, however, as the above examples clearly show, diversification can protect you from a once-in-a-lifetime financial crisis or an unscrupulous investment manager.