I was thinking about the real estate market.

Ryan is one of the smartest guys I know—and certainly one of the savviest real estate investors. His investing success made him a wealthy man, and he lived like one, in a sprawling, high-tech house, valued at $2.4 million, that he shared with his wife and two kids. Then about a year ago, just as the real estate market was starting to skid, and with both kids now in college, Ryan and his wife sold the $2.4-million house and “downsized” to a one-million-dollar establishment. And just recently I learned that Ryan had sold the million-dollar-house, at something of a loss, and was hoping to rent a little place somewhere.
I was sorry to hear it, but I didn’t need to ask the reason. Clearly, with his money tied up in a portfolio of properties that were fast losing their value, Ryan needed cash simply to stay afloat.

“How did you escape making a similar mistake?” my wife asked after I had told her the sad news about Ryan.

“I learned the lesson at my mother’s knee when I was seven,” I replied: “’Don’t put all your eggs in one basket.’ Didn’t you hear that when you were a kid?”

Janine thought for only a second, then nodded.

Of course, we all learned it. In my case, I think it was when I finally got tired of always being assigned to right field when we played baseball at school. “Maybe you should try another sport,” my mother suggested. “After all, you shouldn’t put all your eggs in one basket.”

I would hear the same dictum when I devoted so much time to studying math that all my other grades suffered. And when I got on an ice cream kick and wouldn’t eat anything else. And when I developed such a crush on the tallest girl in sixth grade that I had no eyes for anyone else. “Don’t put all your eggs in one basket,” my mother repeated as I sank into each of these disasters. “Keep your eye on the big picture. It’s a varied world out there.”

That is precisely what Ryan forgot. A business school graduate and an expert in all the complexities of real estate investing, he neglected this simple wisdom from childhood—and he put all his investing eggs into the real estate basket.

Does this mean that investing in real estate is a bad idea? On the contrary. It is a very good idea. As investment categories go, real estate, over ten-year periods, is typically a very good investment. What’s more, through the power of leveraging, real estate investing offers the potential advantage of “multiplied” gains, although that entails the risk of multiplied losses as well. That is, if you borrow money to invest in real estate—as most people do, putting up a portion in cash and the rest as debt—your returns are magnified on both the upside and downside. If the property increases in value, your gains are greatly multiplied because you’re getting a return on the whole amount invested, even though you only laid out a small portion from your own money. But if the property decreases in value, your losses are also multiplied: you’re responsible for the debt as well as the lost value.

That’s what happened to Ryan. And it happened, not because he was naive or because real estate is a bad investment; neither is true. It happened because Ryan forgot the childhood wisdom about not putting all your eggs in one basket. In investment terms, he concentrated all his resources in only one asset class; that’s why he’s hurting today.

What’s an asset class? Here’s how I define it in my upcoming book, The Cure for Money Madness: “An asset class is simply a group of investments with similar characteristics such that the investments behave the same way in the marketplace.” Specifically, the companies have similar size and growth characteristics, and so they behave similarly as investments. Large, fast-growing companies—Microsoft , Nissan, General Electric, and FedEx, for example— behave similarly to one another, even though they represent different industries. By the same token, small, slow-growing companies behave, as investment assets, like other small, slow-growing companies; stocks in small manufacturing companies, for example, no matter what the companies manufacture, tend to go up and down together.

So do real estate investments. They rise or fall in value as a class, as recent events illustrate: when mortgage money was readily available, demand for houses, to take just one example, outstripped supply; house values rose, and investors in housing made fortunes. As they did so, the investors’ tendency was to ply their gains back into more real estate investing, concentrating in this one asset class even more.

That’s what Ryan did, and for a good number of years, as his leveraged gains registered as nothing less than spectacular, plowing everything back into this one asset class must have looked like a good idea. Maybe Ryan grew giddy on this soaring wealth, and maybe the giddiness seduced him into concentrating more and more resources in these persistently rising investments. It was Ryan’s money madness gone wild; he was hitting not just home runs but grand slams on every at-bat, and it must have seemed to him that nothing could go wrong.

I think that kind of madness is just human nature. We stop thinking when we’re on a high; we stop seeing things clearly. By the same token, when we’re low, we see too sharply and narrowly, and think too much. If only there were a mechanism to keep us level—at least where investing is concerned: to stop us when we’re carried away by some infatuation or other, and to move us along when we’re stuck in a rut.

There is. It’s the Rainbow Portfolio™, and I created it for just these reasons: to stop me in my tracks when I get giddy and to keep me going when I get low. In both cases, the Rainbow Portfolio™ is a fail-safe mechanism that automatically reminds me of what I learned at my mother’s knee.

Had Ryan been a Rainbow Portfolio™ investor, for example, it would have forced him to take some of his gains and diversify into other assets—large- and small- and medium-cap stocks, international and domestic, value and growth stocks, commodities and bonds. Automatically, the losses he is suffering today in his real estate investments would have been offset, or at least mitigated, by gains from other investments. What’s more, instead of being forced to sell his family home, as he must now do, he’d be able to stay put, despite the house’s dwindling value.

That’s why ‘Don’t put all your eggs in one basket’ is the most basic, most profound, most important investment mantra there is. It even trumps that other classic, ‘Buy low, sell high.’ Another friend is a case in point.

I’ll call him Frank. Like Ryan, he was a real estate investment wizard. So stunning was his fast climb to wealth that he actually disdained the kind of investing I advise, and we used to kid one another about our opposing investment ideas—mine for multi-asset, passive investing, Frank’s for go-getter, highly leveraged investing in real estate.

Until the day, not too long ago, when Frank phoned to say he was desperate. Plunging real estate values were reducing his net worth steadily and substantively. He did not know where to turn or what to do. What could I advise?

“How much of your portfolio is in real estate?” I asked.

Frank did some quick figuring. “Ninety-six percent,” he said.

I gulped. “Sell,” I said.

“But I’ll lose a fortune selling at the bottom of the market!” Frank protested. Such an idea—selling low, especially after having bought fairly high—was simply anathema to him, schooled, as we all are, in the principle of buying low and selling high. It’s an important principle, but in Frank’s case, it clearly came in second to the eggs-in-the-basket principle. Simply put, it is better to sell low and diversify than to have nothing at all.

So I refrained from mentioning that Frank was losing a fortune anyway. Instead, I argued that with that much concentration in a single asset, he was looking not just at loss but at wipe-out. “The first thing you need to do is avoid total disaster,” I asserted, “and that means reducing your real estate allocation from ninety-six percent to fifty percent. That way, even though it’s painful to sell at a loss, reinvesting what you earn on the sale might very well make you more money in the future. So for now, sell.”

Two guys who hit fantastic heights with their investing have now plunged to unexpected depths. The fault was not in the asset they invested in but in the concentration on that asset to the exclusion of others. The fact is that there are some simple rules about money that keep us safe and, like smoke alarms, alert us to impending disaster. When our money madness makes us giddy, luring us into thinking we just can’t miss, it becomes easy to forget the rules—and such forgetfulness is fuel on the fire.

Ryan and Frank forgot the simple rules—and were badly burned. They abandoned the wisdom we all learned as children: in investing, as in all of life, it pays to embrace the world’s infinite diversity.

It’s a reminder that now may be a good time to count how many baskets your eggs are in…