3.12 How Diversification Protects Your Portfolio (And What Enron Taught Us)

What's your risk appetite and tolerance?

Missed last week? Read it here, or see the full escape map here

The Collapse of Enron

In the 1990s, Enron was hailed as one of the most innovative companies in the U.S., dominating the energy sector and consistently topping “most admired” lists.

At its peak, it was the seventh-largest company in America by revenue, valued at over $60 billion.

But behind the scenes, Enron was hiding massive debts through complex accounting tricks. In 2001, a whistle-blower exposed the fraud, and as the truth unravelled - the company collapsed into bankruptcy within months, wiping out shareholders and triggering one of the largest corporate scandals in history.

Investors obviously had to stomach a huge loss, but hardest hit were thousands of Enron’s own employees:

many had their entire retirement savings invested in Enron stock, encouraged by the company itself.

Because they weren’t diversified, and because Enron stock became literally worthless, many lost not just their jobs - but also their life savings.

Concentration Risk

Betting all your money on one horse is never a good idea. It might pay off - but the odds are stacked against you.

In investing talk, this is “concentration risk”. Your investments are overly concentrated in a single asset, or even asset class.

“As we saw in Why Picking Stocks Fails 90% of the Time - And How to Invest Safely with Index Funds, index funds let you spread your risk over hundreds - even thousands - of companies, without harming your return.

Index funds (and ETFs) can diversify you so much that you are not overly concentrated in a single company, region or sector.

If one of those fails, your investments elsewhere may still thrive and mitigate that loss.

Diversifying Across Asset Classes

But what if all equities crash?

Stock market crashes of 10% happen on average every 18 months.

Crashes of 20% or more? Every 6 years.

In those times we may want a mixture of assets:

• Equities

• Bonds

• Cash

• Property

• Gold

• Crypto for the brave

So that a fall in one asset class is mitigated by another.

Bonds can go up when stocks are down. Cash preserves wealth. Property may give better returns during market crashes, as may a flight to Gold.

Risk Appetite & Tolerance

You can allocate your money to the different asset classes any way you like. It needs to work for you. It depends on two factors:

Risk Appetite = What you're willing to take

This is your ideal level of risk - how much risk you're comfortable choosing in pursuit of a certain reward. It's like saying, "I’m okay with taking some bumps if the potential upside is worth it." It’s often aspirational — how much risk you think you can handle.

It’s the theoretical. It’s easy to figure out. Just think through what kind of losses you are happy with. Are you ok in theory with a 20% drop in your assets, if the long term prospects are still good and allow you to reach your escape number?

But be warned - most people think they can handle risk until the rubber hits the road.

Risk Tolerance = What you can actually handle

This is your emotional and financial ability to handle losses when markets fall. It's your reaction when things go south. It answers the question: "When my portfolio drops 30%, will I panic sell - or stay calm?"

If you have a high risk appetite, but you can’t sleep at night and have your finger on the mouse ready to sell at the worst possible time? Then you don’t have the risk tolerance for your allocation, and you need to diversify into safer assets.

What kind of investor are you?

Ask yourself the following questions. The answers will reveal your risk appetite and tolerance, and will guide you to an asset allocation which is right for you:

1. If your £100,000 investment dropped to £80,000 in a month, you would:

A) 😰 Sell everything and move to cash
B) 😬 Wait it out nervously
C) 😎 See it as a buying opportunity

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2. When you think about investing, what excites you more?

A) Steady growth, low stress
B) A mix of safety and some upside
C) Big gains — even if it means big swings

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3. You’re offered three investment options:

A) 4% return, almost no chance of loss
B) 6% return, with small ups and downs
C) 10% return, but it could drop 30% in bad years

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4. How long could you leave your investments untouched?

A) Less than 3 years
B) 3–7 years
C) 10+ years

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5. In a market crash, you’re most likely to:

A) 🏃‍♂️ Pull out before it gets worse
B) 📉 Worry - but try to hold on
C) 📈 Stick to the plan or invest more

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What Your Answers Say:

• Mostly A: 🧊 Low Risk Tolerance & Appetite — You value stability. Cash, bonds, and conservative portfolios may suit your emotional style.

• Mostly B: ⚖️ Moderate Risk Tolerance & Appetite - A balanced portfolio with equities and bonds could be your sweet spot.

• Mostly C: 🚀 High Risk Appetite & Tolerance - You’re comfortable with volatility. Long-term equity growth and higher-risk strategies might suit you.

Once you know yourself better, you can start to think about what allocation may suit you..

Recap

• The Enron collapse shows what happens when you don’t diversify.

• Index funds reduce concentration risk by spreading across thousands of companies.

• Diversifying across asset classes can protect you in market crashes.

• Know your risk appetite and tolerance - they’re not always the same.

Up Next: Asset Allocations - picking the path to escape

What’s your risk appetite and tolerance? Are you all in risk, or are you the slow and steady type? Let us know in the comments below!

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Disclaimer: This content is for informational and educational purposes only. It does not constitute personal financial advice. Everyone’s situation is different — if in doubt, speak to a qualified, regulated financial adviser.