Are Your Investments Truly Diversified?

00:00:28
Hello and welcome to the Retired-ish podcast, where we discuss all of the complicated stuff that sneaks up on you nearing and in retirement and try to simplify it in a digestible and educational manner. I'm your host Cameron Valadez, and today we are talking about investing and, more specifically, how to diversify properly or appropriately when investing. This episode is a healthy one. I'm going to go over a lot of information that could be extremely helpful to you over the remainder of your investing lifetime as long as you actually implement what you learn. I know a lot of the concepts and methodologies that I talk about today will be controversial to some of you that may consider yourselves savvy when it comes to investing. Some of my opinions go directly against most of what Wall Street and the media like to tell you, even many financial professionals and authors out there, but not all. There are some who share similar opinions as I do. This is mainly because people crave complexity and excitement, especially when it comes to investing.

They want things to seem more interesting, and the financial media, whether it be on TV, the paper, Internet, and Wall Street, they know this, so they exploit it. However, as you will learn, most of it is unnecessary. Please understand that I am not trying to convince you of anything or, more importantly, sell you on anything. I am simply educating you on the realities of investing. So hopefully, you come away from this episode with a good understanding of how diversification should work and the way I believe you should be looking at your own hard-earned savings and investments.

00:02:09
So let's get started. Diversification is commonly referred to as the only free lunch in investing. It's one of those simple but not easy strategies that is such a low-hanging fruit that is available to anyone. You don't need to be a large multibillion-dollar hedge fund to implement it. Diversification is simply a way to reduce risk. I would actually say volatility instead, which, in other words, is the degree or magnitude of the ups and downs, let's say, in your investment accounts or your overall net worth. But it's important to understand that diversification is not by any means a panacea or a magic bullet. It does not guarantee you will make a profit or that you won't lose money at any given time. The ultimate goal when diversifying is to be less wrong, especially in the context of retirement planning or planning to have money for a goal. Trying to pick a stock that gives you, say, a 30,000% return in five years isn't a goal. That's speculation. But we are humans. I get it.

Avoiding the losers is much less exciting than gambling on the winners. In fact, it's not exciting at all. Investing in the biggest and best companies in the world by owning stock in them for long periods of time is not gambling unless you behave as such by trading and thinking you can pick the best one or two stocks or you want to constantly change your investments because you get hot stock tips from someone. If you properly diversify, you're more likely to have a less volatile ride when it comes to your investment journey. For most people, this can actually help them stay the course, remain invested, and not make as many financially damaging decisions as they otherwise might.

For example, if your sister-in-law's accounts are down 35% at any given time, but you're only down 25%, and you're both invested fairly similarly, you're likely to be more accepting of your performance and not make any drastic changes. You will also greatly reduce the chances of picking a loser and or having a permanent loss of capital if the beloved company you own 15 plus percent of in your portfolio goes down.

00:04:31
Like maybe the company you work for, for example. Diversification can add a higher probability that you meet your long-term goals. But again, it is no bulletproof vest. The one thing I really want you to remember from this episode is that diversification will not protect you against dramatic downward movements in stock or bond markets during the occasional worldwide panic attacks that we've all seen before. When these happen, which is normal in investing, the market doesn't care. Even if you think you're diversified because you own, say, some healthcare stocks, a corporate bond with a really high-interest rate, mutual funds, some gold mining stocks, and maybe you don't own any high-flying technology stocks or oil companies, it won't necessarily matter. They are all very likely going to go down.

Or I like to share the other one that people think will help diversify their investments even more, where they have some money that they manage on their own and then the rest with, say, an investment professional. Or maybe they try and have multiple different investment professionals or firms. Sorry to be the bearer of bad news, but this isn't going to save you during a worldwide crisis either. Having a bunch of different firms or people managing portfolios is also a terrible idea for many other reasons, but that's beyond the scope of today's discussion.

00:05:55
However, there are many other instances where proper diversification will definitely do the job it's intended to do. For example, what if a publicly traded company that you own via stock goes bankrupt or falls off the face of the earth for one reason or another? RIP Enron, BlackBerry, or Kodak. Remember those?

If you didn't own, say, 20% to 30% of that company's stock in your retirement or your investment portfolio, guess what? You probably ended up okay. Now, you may think that's an extreme example, but it's really not. There are a lot of folks out there that receive part of their pay or a lot of their pay via company stock awards and have large portions of their net worth tied up in the company they work for or maybe used to work for. Some other examples you could reference in identifying the benefits of diversification could literally be any of the investing crazes throughout history, whether it was Japanese real estate in the late eighties to early nineties, the tech bubble of the early 2000s with internet stocks, or even the recent cryptocurrency craze.

If you didn't take the majority of your money and invest in any one of those investments or crazes at that time, you're likely okay. And that would be diversification doing its core job. And by the way, I have only given examples of diversifying amongst stocks. I wasn't even including diversifying with other asset classes like cash, real estate, or government bonds, et cetera. Now, most people think of diversification in terms of don't put all of your eggs in one basket, which is, in fact, diversification in the simplest form.

00:07:37
However, when it comes to investing, there's more that I think you need to understand, although it's not as simple as owning some stocks, some bonds, and maybe some cash or gold either because it can look like you are diversified among these different assets on the surface or when looking at an account statement, for instance. But when you drill deeper, and you really get a good understanding of what exactly it is that you own, you may not be very diversified at all. And I'll explain why in a minute.

Okay, so now that we understand why we would diversify and the expectations that come along with it, let's get into the nitty gritty on what to consider when looking to diversify your investment or your retirement portfolios, along with definitely what not to do. So let's shake things up and start with an example that encompasses a lot of what I want to teach you about diversification.

Okay. Remember how I just mentioned that it can look like you're diversified, but you really aren't? Well, this all too common example will show you how that happens. Not kidding. I see this with almost every investor I first come across, whether they invest themselves online or have a financial advisor of some sort. And this may be similar in some ways to your own situation. My goal is to show you what not to do and provide some insight on why and what you should consider instead.

Okay, so we have two hypothetical retirees, husband and wife. They have an overall portfolio of around $2 million, not including their physical, real estate, and their business, which is made up of four different types of accounts, some retirement accounts, and one trust account. The husband's retirement accounts are at a big financial institution.

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We'll call it financial institution A with commercials on TV that everybody knows. And the wife's retirement account is at her former employer, which is also held by a big company in the retirement plan. Their trust account is at big financial institution B we'll call it, where they have access to a call center. Even with employed financial advisors, they have twenty-eight holdings in the trust account, thirteen holdings in the husband's retirement account, one holding in the wife's retirement account, and three holdings in the husband's Roth IRA. Now, for the sake of this episode, we're going to ignore whether or not these investments are even in the correct accounts for tax purposes, yada, yada, yada. And instead, just focus on the diversification aspect.

This is an example that is drawn from what I have actually seen many times over the years. Don't worry about needing to know what all of the investment jargon means because I'm going to explain them to you in layman afterward. In the trust, they own 7% in Cisco stock, 9% in Amazon, and 24% in Microsoft stock. That's a total of 40% in just three companies, two of which are arguably in the same sector of the US economy, which is the technology sector. The other 25 holdings, or 60% of the account, are made up of smaller publicly traded companies purchased after reading some articles about them over the years, as well as ten different mutual funds from various investment institutions. Most of the 60% is in the mutual funds. Now, three of the mutual funds are what are called large-cap growth funds, each from a different investment company.

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Two of the seven remaining mutual funds are what are called alternative investments that are meant to invest in a way that doesn't act exactly like the stock market, although they still invest in stocks to an extent. Again, each fund is from a different company, but the specific strategy of those alternative investments is the same. The five remaining mutual funds are a mixture of a balanced fund, a conservative asset allocation fund, a high-yield corporate bond fund, and the last two mutual funds are both called strategic income funds, offered yet again by two different investment firms. These funds typically have a mixture of stocks, bonds, and even some real estate investment trusts or REITs. Now none of the stocks or the mutual funds in the trust are invested in any companies outside of the United States. All of it is in the US. The majority of the fifteen smaller individual stocks that they own are companies in the internet and telecommunications sectors of the US economy.

The husband's retirement account has a mixture of thirteen different mutual funds and exchange-traded funds, also known as ETFs. About half are in corporate bond mutual funds, and the other half are in US stocks, once again. The Roth IRA has three low-cost index funds. One tracks the S&P 500, which represents roughly the top 500 companies in the United States. One represents the entire stock market, and the last one is what is called a money market mutual fund. Which is basically an alternative to cash.

00:12:56
The wife's retirement account at her previous employer is what is called a target date fund. Essentially, it's a fund that changes how it invests as one approaches their stated retirement year. And her target retirement year was actually three years ago because, again, she's already retired. Okay, I know that was a lot. Too much, in fact, and trust me, I agree. But as I said, this is very, very common. So this time, I will recap the example but instead, explain what the retired couple sees when they look at their own investments.

Here we go. We have four different accounts at three different places. We definitely don't have all of our eggs in one basket. Good thing. We have forty-five different investments across all of our accounts. We definitely have our investments spread out pretty well. With some of our bigger investments in mutual funds, we split the strategy between two different investment firms so we don't have to bet on just one of them. And again, I'm referring to those two alternative investment mutual funds and the two strategic income funds. That Microsoft stock has really grown a lot for us over the years. We owe a lot of our success to that stock. We have stocks, bonds, cash, and some alternative type of investments so that we're diversified.

Okay, so as you can imagine, I can go on and on about this particular scenario. But instead of rambling any further, let me explain to you what's really going on under the hood here. Having accounts at multiple different institutions, what we call custodians, does not improve your diversification.

It may feel like it does, but it's not really doing anything besides causing you more headaches. With multiple online logins, statements, systems, and things that you have to keep track of. If a particular company that you're invested in were to go bankrupt, let's say, and end up folding, it doesn't matter what custodian you are using to hold that stock, it will end up worthless regardless. Having forty-five different investments is what I call collecting, not investing. Eventually, you will just have a random collection of different investments over the years, and your portfolio will eventually have no real purpose or direction.

00:15:15
I'll put it to you this way and rather bluntly. If you are someone who can't help but buy individual stocks and speculate, why have twenty-plus different stocks rather than own the latest one that you bought and have the most conviction in since that's why you just bought it, right? It must be the one that's going to hit it big. If you own tons of individual stocks, you, therefore, must think that there's a chance that you're wrong about some of them. In which case, why invest in individual stocks at all?

Not only that, but in this couple's case, most of their individual stocks are in one or two sectors of the US economy. If another tech crash were to come or any crisis across the world, they won't feel very diversified anymore. Now, when I see two or more mutual funds or ETFs that are virtually the exact same thing, but there are multiple investment companies used, this always puzzles me. Turns out that you probably pick them after assessing past performance or some kind of star rating online, whatever that means to you.

But I will tell you that there will always be one that is cheaper than the other. So if they are doing the same thing and one is more expensive, why invest in the more expensive one? If it's because you think one may do worse than the other or vice versa, well, that's anybody's guess at any time. One year, fund A may do marginally better than fund B, but then fund B may do better the next year. All the while, you're paying extra for the more expensive one.

00:16:53
As a side note, another strong opinion of mine is that these alternative investments that I spoke of earlier simply aren't needed, especially for retirees. If you have a well-constructed financial plan and you have specific purposes for your different accounts. So say account X is meant to grow over twenty years to outpace inflation, and account Y is meant to provide you income for the next three years, then they would be structured in a way that the volatility shouldn't matter too much to you. Alternative investments are just an increasingly complex, opaque, and expensive Wall Street product that hook people and many investment professionals during times of extreme market volatility so that they can possibly reduce that market volatility by potentially not moving in tandem with the stock market. That's what these alternative investments are supposed to do, which is something that most investors, especially retirees living off their investments, shouldn't need unless they don't understand why their money is invested the way it is and they don't have a financial plan in place and accounts with a purpose.

These investments come in all shapes and sizes, mutual funds, and the like. There are other types of investments that don't typically move in the same direction as the stock market at all times, and they're often cheaper to own. Investors love to believe the why with alternative investments, which is typically something along the lines of you get to participate in the stock market with limited downside to some extent, or the advisors that use these with their clients, they tout better returns on a risk-adjusted basis. This asset class is oftentimes pushed when an investor comes to these professionals again during times of extreme uncertainty or market turmoil because they are looking for a silver bullet and they have been spooked out of owning stocks. Investors and many professionals buy into the idea or perceived usefulness of these alternatives, but they are simply a tool to potentially ease the mind and the behavior of the investor or even the advisor.

00:19:08
They see them as a risk management tool, but what they fail to see is that they are trying to mitigate a risk that does not exist, which is the fact that, over the long run, the investor may have a permanent loss of capital in stocks. I can say long-term because that's the time frame one would own stocks, to begin with. And most of these alternative products nowadays they aim to counteract or reduce the risk in stocks as opposed to other less volatile assets like bonds, commodities, et cetera. Now, I say this long-term risk doesn't exist because stocks are one of the only asset classes that can offer both rising income from dividends and increases in value over the long run. And by the way, you can participate in that rather effortlessly and inexpensively.

In short, alternatives may seem like a way to diversify, but I think that use misses the point completely, and most investors are better off without them. Okay, sorry for the rant. I just had to say that.
Back to our example. Remember, the couple owns what is called a balanced fund and an asset allocation fund. And actually, in my example, it was a conservative asset allocation fund. Well, these types of funds own hundreds, if not thousands, of stocks for you. And there are an endless number of mixes that they may have. For example, a balanced fund or asset allocation fund may own, say, 50% in bonds and 50% in stocks. It may also be something along the lines of 65% in stocks and 35% in bonds or cash or whatever.

The key is that a lot of them can and do change the percentage allocation to each, and you won't even know it if and when they do. In this example, they seem to own them simply to make their lives easier by having an investment firm, the one that runs the mutual fund, diversify for them. But if they don't trust themselves and want someone else to pick stocks and allocation percentages, why would they be doing it themselves with the majority of their other money? This is simply an example of not truly investing according to a goal or having a purpose for certain buckets of money. Another personal opinion of mine is that corporate bonds specifically do not serve as good diversifiers to stocks in a portfolio.

00:21:33
And this couple owns corporate bonds via their corporate bond mutual funds. But many people see them simply as general bonds and that they are safer than stocks just because they're bonds and they're less volatile. So they load up on them. Now, here's why I think having primarily corporate bonds specifically is an issue. Instead of owning a company via stock ownership, by owning their bond, you are choosing to lend to them.
When you buy a bond, they are borrowing that money and promising to pay you back at the end of a term with interest. So ask yourself why would the biggest companies in the world borrow money? It must be because they are convinced that they will be able to spend or invest that borrowed money and earn more on it than what they will owe back to you in interest. This would be their profit.

So who benefits from the extra profit some of these companies might make? You guessed it, the stockholders. In addition, if large company A, we'll call it that everybody in the world knows and has heard of, suddenly runs into trouble because we have just learned that the company's finances, let's say, have been falsely stated for the last three years, their stock price would likely plummet, but likely so would the value of any bonds they have outstanding. Since the risk of them not paying bondholders back is suddenly higher. In this case, the stock and the bonds would likely move in the same direction. This doesn't help much when it comes to diversification away from stocks.

00:23:08
Therefore, if you have a need for bonds in your portfolio or want part of your investments to diversify away from stocks because you want to reduce the volatility, I would consider exploring maybe government bonds, also known as US treasuries, instead. These bonds are issued and backed by the full faith and credit of the US. Government, and they're not issued by public companies. Therefore, there is much less correlation to the stock market than corporate bonds. In fact, there are times when government bonds will actually move in the opposite direction of US. stocks, such as during the great financial crisis, which is the purest form of diversification.

Now let's take a moment to understand why not including investments from other areas of the world or other countries might turn out to be a mistake. And remember the couple in this example. Basically, all of their money is invested in the United States. They have almost nothing outside in other countries. In general, international stocks over the last fifteen years or so have not done as well as the US stock market. But historically, this hasn't always been the case. In fact, non-US stocks have outpaced US stocks for extended periods in the past, such as the mid-1980s and from the late 1990s into the mid-2000s. So you want to be careful not to rely too heavily on recent events or, in this case, recent US stock returns. Don't confuse familiar with safe. People are familiar with the US market's dominance as of late, but that doesn't mean it's “ safer” or always will be compared to other parts of the world. No one knows which countries will experience prolonged periods of underperformance or economic turmoil or when they will experience it. This is what international diversification can help prevent. You don't need to try in time markets or guess. And there are plenty of great companies that operate outside of the United States.

00:25:13
Don't fall victim to what we call recency bias. During any system or worldwide crisis, most stock markets typically perform poorly, US or not, such as the war in Ukraine, for example, or worldwide inflation. So when these crises happen, most people think that they actually aren't diversified when they own international stocks and US stocks because, typically, they all fall at the same time and sometimes to the same degree. However, you should have some global diversification because you don't know how fast or when certain countries will recover from such global crises.

Global diversification makes even more sense over longer time horizons. For those with long-term goals like funding your retirement income for the next twenty-five to thirty years, the United States could fall into a prolonged period of economic turmoil while a handful of other countries thrive. So I would encourage you to include companies outside of the United States in your investment allocation.
Okay, so I saved the big kicker here for last. The number one problem with this couple's diversification strategy is the extreme amount of what is called overlap that these two have amongst their investments in their accounts. Which ultimately means that they are not nearly as diversified as they think they are.

Here's what I mean. First, remember that they have 7% in Cisco stock, 9% in Amazon stock, and 24% in Microsoft stock. These are the individual stocks themselves. However, they also own a lot of US stock mutual funds, index funds, and ETFs across all of their accounts, which are essentially baskets of hundreds, if not thousands, of US stocks. Once we look into the three growth stock mutual funds that they own, we see that Microsoft actually makes up 14% of each of those funds from all of the different companies. And Amazon makes up close to 6% in each of those three funds. So therefore, about an additional 20% of the money they have in those three mutual funds is in the top two stocks that they already have nearly 40% of their money in before even looking under the hood of the mutual funds.

00:27:38
Now, basically adding insult to injury, the balanced fund and each of the alternative funds also own Microsoft stock. Again, this is nothing against Microsoft, this is just an example. But when you really look, this couple has probably close to 35% in one stock and 50% to 60% of their investable net worth in just three stocks. Fund-like investments where they own hundreds if not thousands of stocks or bonds are not bad investments by any means. In fact, they are extremely useful and practical, not to mention easy.

However, you should have at least a basic level of understanding of what you own and how it plays with or without the other investments that you own. Be mindful of owning individual stocks and then accidentally and unknowingly owning much more through these various funds. Some overlap is okay, in my opinion, but it's important to be mindful of how much you have. In addition, as you have now seen, just because you are in mutual funds or exchange-traded funds, those ETFs or index funds, et cetera, this does not mean that you are diversified. Owning a mutual fund is like saying I have a vehicle. Okay, what kind of vehicle? A boat? A car? Motorcycle? Semi truck? What exact purpose do they serve? Do they transport people? Supplies? What bells and whistles are on them?

00:29:05
You get the point. There are thousands of variations of things that could be going on in those funds at all times. Know what you own and why. You could own five mutual funds, all doing the same thing, and own the same stocks, bonds, or whatever. And as I said in our example, some may cost more than others. Actually, it's inevitable. Then why have any of them besides the cheapest one? Sounds logical. But trust me, I see this mistake all the time. What something does is more important than what it is.

While this couple does have some level of diversification, they are not nearly as diversified as they could be. Meaning the probability of them reaching their long-term investing goals is diminished. There's more risk to their plan than needs to be. The worst part about this situation is that they think they are diversified simply because of the amount of investments they have, the number of accounts they have or the number of mutual fund or ETF companies they spread their money throughout, and the number of custodians holding onto their money. And as you can tell, this is not the case.

Now, I have one last important thing I want you to understand about diversification, and it's an important one. That is, when you're aiming to diversify to reduce volatility, there should be some investments that are not working at some point in time while others are. That's true diversification. This means you have some investments that aren't correlated to others. Meaning they don't move in the same direction and to the same magnitude all the time.

For example, you could have an investment that's up 30% while you have another one that's down 7%. Or you could have your investment up 30% and another one that's only up 5%. Same thing on the downside. We can simply call this being uncorrelated. Investments that are uncorrelated are ones that don't move together often.

00:31:02
I will say that truly uncorrelated investments are very hard to own long-term, unaided. But they can reduce volatility efficiently. As an example, if you owned an investment that is uncorrelated to the US stock market over the long term, such as US government treasury bonds for example and stocks go ripping up during a given year but your treasury fund drops in value significantly, you may be inclined to sell it thinking it's a loser when in reality that's how you know it's doing its job. It probably shouldn't be moving in the same direction, given what's happening at that time in the US economy.

Again, if you understood why you were buying it in the first place, you'll be more likely to stick to it through good times and bad. Smart investors know that if they are well diversified, they will almost always have positions that have underperformed at any given time. To get the real benefits of diversification or your free lunch, you have to be willing to accept that reality and have the discipline to stay the course.

If you don't stick with your investment strategy long enough, you may not actually see diversification work in real-time. International stocks underperforming the US stock market over nearly the last fifteen years is a perfect example. If you haven't owned both for over that period of time, you're not going to notice the true benefits that international investing can have. This is why diversification is essentially useless without true financial planning in place.

A good financial plan addresses many possible outcomes and helps you understand how to handle certain phases of retirement and make decisions. Now that you can make decisions comfortably, you are more likely to implement these strategies, which will, in turn, help you with good investment behavior, allowing you to stay properly diversified. So, as I mentioned at the beginning of the episode, although the concept of diversification is simple, it is by no means easy to do. This is why financial plans that are monitored and implemented year in and year out during retirement are so crucial. A plan gives you the most powerful insight into a confident investment strategy, which is expectations.

00:33:21
When you have defined goals, you can plan for them and have realistic expectations of reaching them straight from the start. For example, if you're truly diversified, you likely won't get, let's say, 70% returns in the year your coworker did by buying a certain type of cryptocurrency that went gangbusters. But you'll also understand that you didn't need to. Secondly, you won't experience the extreme risk of not achieving your goals if you were not diversified and instead invested just as your coworker did when they eventually experienced the inevitable extreme downturns. Had you experienced this without a plan, you likely would have abandoned your investments to chase whatever they were doing to then find out you didn't get the results that you thought you would. And the worst danger of this is that once you get burnt that bad in investing, you likely won't invest ever again, which is one of the biggest mistakes someone can make.

That's all for today's show. I hope this prompts you to take a second look at your investments and your hard-earned savings and encourages you to learn more about how to truly diversify, given your own situation. I will revisit the topic of diversification much more in future episodes, especially as it relates to owning a high degree of various stock awards, such as stock options, RSU's, and things of that nature from your current employer or previous employers. If you have any more questions regarding diversification and investing that I didn't answer on today's episode, feel free to ask me a question on Retiredishpodcast.com.

00:34:57
You can go to the Ask a Question page at the top. I will also include a link to it in today's show notes for the episode and ask a question. I will do my best to answer it in a future episode. Thanks again for tuning in and following along. See you next time on Retired-ish.

00:35:38
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