In 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.
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.