What a Bankrupt Detroit Teaches Us About Investing

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In 1948, Secretary of Commerce Charles Sawyer called Detroit's automobile industry "a symbol of the way in which the American economy could best provide the average American with a steadily increasing abundance of the things he wants and needs."

Two weeks ago, Detroit filed for bankruptcy.

Pundits this week pointed fingers at a city that promised too much, spent with abandon, and relied heavily on a single industry. They cite a poorly run government, myopic city planners, and even fraud. In most cases, they are right.

But the largest driver of Detroit's demise is a simple, startling fact: The city's population declined 65% in the last six decades. No city can survive such an exodus. It's actually amazing Detroit's finances lasted this long.

The Motor City was home to 1.9 million people in 1950, at the time nearly identical in size to Los Angeles. Today, 700,000 inhabit Detroit, or less than a fifth the size of L.A. That works out to 2.2 people leaving Detroit every hour, 24 hours a day, for the last 63 years. If the number of people who left Detroit in the last 60 years formed their own city, it would be the nation's ninth largest, ahead of Dallas, Texas.

The financial woes linked to Detroit's shrinking population have been known for decades. A 1991 article in the Times-News was prescient: "Detroit's population loss could be financial disaster," it wrote.

And Detroit tried to avoid its fate. Total city spending was cut by more than $1 billion, or 33%, between 2006 and 2010, including a 77% reduction in "recreation & culture" spending, a 72% cut in capital outlays, a 41% reduction in spending on roads, and a 44% cut in "health & welfare" spending.

But the city made pension promises during a period when its taxpayer base was more than twice the size it is today. With an unemployment rate of 16% -- more than double the nationwide average -- there is a shrinking base of workers left to tax. With a median income of $27,000, or about half the nationwide average, those who are employed have little income to tax. According to Detroit News, nearly half the city's 305,000 properties didn't pay their tax bill last year. Seventy-seven city blocks had only one owner who paid property taxes in 2012. You cannot run a city like this.

What Detroit's fall means for investors may be more symbolic than direct.

Investors hold some $1 billion in Detroit general obligation bonds, and $5.3 billion of bonds backed by the city's water and sewer revenue. That's barely a rounding error in the $3.7 trillion municipal bond market. And not all of Detroit's bonds' value will be lost; part will be recovered post-bankruptcy, and parts are backed by bond insurance companies. The direct investing fallout from the city's bankruptcy is nil.

Symbolically, Detroit teaches us three things about investing.

Firstly, it was overwhelmingly reliant on the auto industry. When the fate of three companies -- General Motors , Ford , and Chrysler -- turned, so went the entire city's fate. Evan Soltas of Bloomberg wrote: "Detroit's dependence on cars wasn't exactly the problem. It was dependence itself. Cities should never go all in on any industry, cars or otherwise. It didn't realize that until it was too late."

The same mistake often trips up investors. We preach diversification at The Motley Fool because a lack of it can be one of the surest routes to disappointment. William Goetzmann of Yale and Alok Kumar of the University of Texas once showed that the least diversified investors underperform the most diverse investors by an average of 2.4% annually. Things change unexpectedly, and often for the worse. Diversification is the best way to mitigate that risk.

Secondly, Detroit shows how organizations that can't adapt eventually crumble.

Before it was a technology hub, San Francisco relied on shipping, and before that, gold mining. Before New York was the financial capital of the world, it was the garment capital of the world. Detroit enjoyed the auto boom, but it never found its second act.

Adaptation is a key requirement for any organization's survival, including companies. We're always looking for companies that adapt to changing circumstances. Amazon started as an online bookstore and adapted into the world's largest store, period. Netflix started as a DVD-by-mail company and adapted into a streaming video service. History provides two constants: Change, and punishment for organizations that don't adapt to change.

Lastly, Detroit provides a sad lesson in the need to save for one's self. Tens of thousands of retired Detroit public workers wait anxiously for word on if, and how much, their pension benefits may be cut. Their story may not be unique. According to Credit Suisse, 97% of S&P 500 companies with pension plans are underfunded. The Congressional Budget Office wrote in 2011 that, "By any measure, nearly all state and local pension plans are underfunded." The hard lesson is that you can only truly rely on one person -- yourself -- to save for retirement and look after your investments.

Never let a serious crisis go to waste. That includes learning from Detroit's fall. 

If you're interested in more on how debt impacts the economy, check out my new report, "Everything You Need to Know About the National Debt." It walks you through step-by-step explanations about how the government spends your money, where it gets tax revenue from, the future of spending, and what a $16 trillion debt means for our future. 

The article What a Bankrupt Detroit Teaches Us About Investing originally appeared on Fool.com.

Fool contributor Morgan Housel has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Ford, General Motors, and Netflix. The Motley Fool owns shares of Amazon.com, Ford, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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