Diversification…Lesson #2

Iformulafoliosn my last blog post I wrote about diversification and how most individual investors and retail financial advisors and stockbrokers get it WRONG!  I apologize if I upset some of you.   And to the advisors that follow me, you should be ashamed of your “strip mall” firm or Wall Street master that has made you their puppet. (If you missed my previous post, please click here)

Let’s continue your lesson on diversification and asset allocation.  Diversification is a common investing idea people like to say makes sense but few actually practice. Many financial advisors, working for the big Wall Street firms, also claim to provide diversification, but do not. That is a shame; because it is a powerful investing tool and you, the investor, deserve it.

What is true diversification? Let’s first explore what it is not:

  • It is NOT owning a broad ETF or two as a “base” for your portfolio.
  • It is NOT owning seven different mutual funds that track sectors of the stock market.
  • It is NOT holding stocks and letting cash dividends build up before buying more.
  • It is NOT owning 15-20 stocks as opposed to three.

Why do these common practices fail the “diversification” test? It fails because real diversification is owning thousands of stocks, not dozens or even a hundred. Furthermore, true diversification is owning thousands of positions even in non-stock investments, such as fixed income and real estate. Simply, it’s owning the whole market, like an index fund does, and owning the correct mix of asset classes. Studies have proven that 91% of investment performance comes from proper asset allocation. Not from choosing Apple or Microsoft or Home Depot or Lowes. The data also proves that a mechanical, rules-based process of asset class selection outperforms emotional, fundamental “gambling”.

So, why bother? Well, first and foremost, diversification greatly reduces the risk of a single company going under. If you own a lot of one company, probably the company at which you work or a single firm you admire because of its products or its charismatic CEO, well, YOU are taking on quite a lot of risk. Companies do fail. CEOs are often overvalued investors, who buy into the myth of their power over the market. Things do go wrong, and it can quickly take your retirement down. But diversification also protects you from yourself. Sorry to call your ego out here, but human nature crashes many retirement dreams. If you own 5,000 companies in a broad ETF, allocating to a pre-determined asset class, it won’t matter if 10 companies fail or even if 100 fail. The successes of some other group within that asset class will more than compensate.

Likewise, you shouldn’t own two pages of mutual funds on the assumption that a variety of managers will protect you from problems, or the next market correction. I recently was reviewing a portfolio from a well know advisory firm. The big brokerage firm you see in every local strip mall, between Little Caesar’s Pizza and the Nail Salon. The statement was easy to read and showed a list of over 25 mutual funds. The problem: when the funds selected are all trying to beat the same benchmark, you haven’t diversified at all. That portfolio overlap and redundancy is an express route to major retirement failure. In addition, the client was paying their high shopping center rent via hidden fees and a cookie cutter approach to investment management.

Owning all those mutual funds and then spritzing in one or two ETFs isn’t the answer either. Buying an index fund or index style ETF with a small slice of your portfolio is just lipstick on a pig. It may make you feel better about the big risk and big fees you are paying.

True Diversification

So, what is it? It is about owning whole markets (classes) through broad index funds or ETFs. And it’s owning the proper mix of those funds across multiple asset classes, including stocks, fixed income, real estate, foreign investments and commodities. It is rebalancing dutifully among those funds as the markets gyrate up and down with opportunities to sell high and buy low. That way, you stay diversified even as changes in the market distort your original portfolio allocations.

It’s really simple, perhaps 10 or 12 index funds across six or eight asset classes. That is top-notch diversification and, ultimately, better performance.  If you would like more information on how we build client portfolios and protect them with AssetLock, call our office today. 678-218-5925.

So You Think You Have a Diversified Portfolio? Think Again…

pie chartIn meeting with folks every week, I can state with quite certainty that few individual investors truly understand what it means to have a diversified portfolio. Most believe that owning 20-50 stocks, or a few mutual funds, means that they are diversified. But they are dead wrong. “Dead” because without being properly diversified, in extreme market situations, a portfolio can permanently lose capital and never recover. This problem will only reveal itself when the market experiences increased volatility and is in the grasp of a bear market cycle.  (So, you feel pretty diversified right now because the market is flying high.)

Those who owned a “diversified” portfolio of technology stocks in early 2000 when the Nasdaq reach 5000, have never recovered. Neither have those who held a “diversified” portfolio of financial stocks going into 2008.

Proper diversification is about managing risk — making sure that when the markets are down, you lose as little as possible, and when they are up, that you recover and capture your fair share of returns. Being well diversified is the “only free lunch” in finance because using methods from proven and scientific knowledge about investing, you can dramatically lower risk without suffering a reduction in returns … and it really is free!

Just like following a prized recipe, the ingredients of diversification are simple to acquire, but rarely followed. Here are three tests to make sure you have a truly diversified portfolio.

Asset Classes. A well-diversified portfolio is not about US stocks — it includes at least six asset classes. You should have at least 5% of your portfolio—but no more than 30% — in all six core asset classes: U.S. and foreign developed countries (Europe, Japan, Asia), emerging-market countries (Brazil, Russia, India China) bonds, real estate and commodities.

Like each instrument in a symphony orchestra, each one of these asset classes plays a valuable role in different economic circumstances. US Treasury bonds protect against economic meltdowns like the one experienced in 2008, but they lose value from inflation and slow down overall portfolio growth. Real estate hedges against inflation, provides a steady income stream, and can appreciate like stocks, but it is not immune to economic cycles. How much to invest in each asset class differs depending upon your stage in life — but everyone should have all six. A retiree seeking income, may have 80% of his portfolio in bonds, but also own global equities as an inflation hedge.

The term asset class is widely misunderstood. Industries and sectors are not asset classes. Economic sectors (technology, utilities, financials, basic materials, or consumer durables) are not asset classes. Nor are the industries within a sector. The software, communication equipment and computer hardware industries are within the technology sector. For U.S. investors, foreign countries are not asset classes.

Number of Securities. Within each asset class, diversified means you must own hundreds of stocks or bonds to reap the returns of that asset class. You do not want any individual company or country (besides the U.S.) to have an impact on your portfolio. A typical MarketRiders portfolio includes over 6000 stocks and 3000 bonds.

For example, if you want exposure to emerging markets, owning 20 stocks from a few different countries won’t do it. Owning a China fund like iShares FTSE China 25 Index Fund (FXI) is not enough diversification. But Vanguard’s Emerging Markets ETF (VWO) allows you to own over 900 companies in 28 countries, giving you fantastic diversified exposure. You are riding entire economies of many countries without worrying about getting hurt by an individual business within them. Sure, you’ll miss the joyride you get owning an Apple (AAPL), but you will also miss the dread when a company like Citibank (C) loses 80% of it’s value.

Funds, Not Stocks. It is nearly impossible to be well diversified owning individual stocks. Trading costs and the software required to own the necessary number of stocks required are beyond the reach of individual investors. So you must own funds.

Actively managed mutual funds have wide discretion in how they can invest. Most funds can invest 10%-25% outside of their “advertised” charter. You could invest in a Foreign Developed country fund and find that a large percentage of your investment is in the U.S. You can’t manage your allocation when your managers don’t have to stick to their charter. It would be like having your guitar player suddenly decide to start playing a flute.

Owning ETFs gives you razor-sharp precision in your allocations. If you own, for example, the iShares Small Cap US Stock ETF (IJR) you won’t find foreign stocks in that holding. And ETFs are dirt cheap — our portfolios are built solely with ETFs and have an average expense ratio of .2% which is an average of 80% less than a mutual fund portfolio. Cheap and precise … how do you beat that?

Look under the hood of your portfolio. Do you own over 10,000 securities? Are your funds overlapping, giving you double or triple ownership in the same stocks? Is your money spread all over the world, in all sectors, all industries, and in all kinds of debt? If not, you are missing that free lunch, and during the market correction and next recession, you will feel it way more than those of us who have taken true diversification to heart.

If you are serious about your money, we are serious about helping you reach your goals.  Please contact our office NOW and allow us to help you get truly diversified.  If you have any doubt, give us a shout!

Regards,

Phil Calandra

Market Drops 400 Points in 2 Days…Should You Worry? What Happens Next?

bull bearThe market has largely just been moving along the past few months. That all changed with last week’s huge drop. The market drops 400 points in 2 days. Despite the sharp selloff, it may be too early to worry about a major correction.  However, pay close attention to market action over the next week or two.  Below you’ll find thoughts from the Chief Investment Strategist at Formula Folios.  Formula Folios is our lead institutional money manager and they don’t think now is any time to panic.

As always, if you have comments or questions, feel more than welcome to reach out. You can use the comment feature below the post for public questions, or drop a secure and direct message to me via the contact form here.

Oh, and be sure to share this to help other people that might be worried about the recent market dip. Just use the Facebook, Twitter, or other share buttons to the left of the blog title.

Regards,

Phil Calandra