The big selloff last week centered around a massive Chinese real estate developer, Evergrande, which is almost certainly insolvent.

Although not many folks around here (including me) had ever heard of Evergrande, the company is the second-largest developer in China and ranks 122nd on Fortune’s Global 500.

According to Wikipedia, in 2020, Evergrande reported revenues of $78.4 billion and profits of $1.25 billion, which is a fairly slim profit margin of approximately 1.5 percent. Last week, they reported that they may not make some of the payments on their $300 billion in debt.

If we assume that all of those numbers are correct, the implication is staggering: their debt is 240 times their profits, and it’s easy to see how they could go bankrupt.

The prospect of such a large Chinese company collapsing caused investors around the globe to wonder whether this was a ‘Lehman’ moment, referring to the 2008 collapse of Lehman Brothers, the storied investment bank that sent our financial crisis into overdrive.

The big question right now is whether the Chinese government will bail Evergrand out (so it’s more like a Bear Stearns or AIG moment), or whether a big, disorderly unwinding is upon us.

For now, the market has concluded that this is not a Lehman moment, as evidenced by the complete recovery by the end of the week. And the thrust of the argument is twofold.

The first argument is that Evergrande is too big to fail, and the Chinese government will step in to prevent a collapse. Real estate accounts for one-third of China’s GDP, so it is deeply in their interest to bail out the company. Plus, Evergrande has 200,000 employees working on 1,300 projects in 280 cities – people are waiting on 1.6 million apartments.

The second argument is that Evergrande holds physical assets, not financial ones like Lehman. The value of the land and housing projects are reportedly worth $220 billion. That’s less that the debt by a long shot, but the value of the land is likely to be more stable than the securities that Lehman held.

On Thursday, Evergrand missed the $85 million interest payment that it warned about over the weekend, which started the fiasco. They apparently have a 30-day grace period before any action is taken, which gives Beijing some time to decided what they want to do.

Right now, the market seems to think that China will step up and bail out Evergrande. My guess is that they will too and the name Evergrande will fall out of our vocabulary as quickly as it came in.

Who knows, though, what will happen – my prediction isn’t worth much, which is why we rely so heavily on diversification. And maybe I buried the lede, but that’s where the real story is here.

According to the semi-annual report for the exchange-traded fund where we get almost all of our emerging markets exposure, the fund held 0.05 percent in Evergrande as of April 30th. Given that emerging markets almost never make up more than five percent of a portfolio, our direct exposure to Evergrande is minuscule.

But, the diversification didn’t stop us from losing money on Monday because the issue with Evergrand could have much larger implications – you can still lose money even when you’re highly diversified. That’s called a systematic risk, and while it’s unpleasant during the hits, it’s why we get paid to take the risks – no risk means no reward.

Furthermore, we believe that some diversification is better than others. While we do include emerging markets in our stock allocations, we don’t include bonds issued by emerging market countries in our bond portfolios. Even though emerging market bonds have higher yields, we don’t believe that they are worth the risks, partly because they are highly correlated with stocks.

Last week was a great case in point – although the US bond market lost almost a half of a percent last week (for reasons unrelated to Evergrande), emerging market bond indexes lost more than twice as much (depending on the index).

We are continuously evaluating what kinds of risks to take and what kind to avoid, but our basic principles haven’t changed much over the years:

• We need systematic risks to earn returns, which have historically been rewarded. Said more simply, we take market risks.
• We don’t take much non-systematic risk by taking concentrated risks in individual companies. Our market risks are well diversified.
• We take some systematic risks in our bond portfolio but avoid others, like debt issued by emerging market countries. The risk isn’t well compensated in our view, and the bad outcomes often show up when you don’t want them (when other bad things are happening).

So, pay attention to the Evergrande story, but not too much attention because we’ve done what we can to protect ourselves. We don’t have worthwhile predictions, but we have protections that make sense and allow us to take the risk we need in hopes of getting the returns we all want.