Can You Spell D-I-V-E-R-S-I-F-I-E-D?
Today’s economic news can distort your sense of fiscal reality. Here are three errors many people are making — and how you can avoid them.
If you follow my radio and television shows or read my books, you know how often I use the word diversified (and its sisters diversify and diversification). That’s because, in the world of investments, I believe these words matter more than just about anything else, and I’m sure that nearly all professional advisors and money managers would agree.
I’m sure I don’t have to define the word for you — but there’s a big difference between knowing what diversified means and having a portfolio that’s truly diversified.
I’m often reminded of this when a new client comes to us saying something like “I’ve got stocks, I’ve got bonds — I think I’m diversified.”
When we look closely, though, we often find that all, or almost all, of the client’s money is in just one type of stock — say U.S. large-cap. Or someone may have 10 or 15 mutual funds and think they’re diversified, when in fact each of those funds invests in the same type of securities — municipal bonds, say. These folks really have just one type of mutual fund, and they have it 10 or 15 times. Indeed, many people who believe they own diversified portfolios actually own investments that are merely redundant to each other.
Others go in the opposite direction, gambling on a tiny handful of investments that they’ve been led to believe can’t lose. For example, one recent caller to my radio show wanted to know whether he might have a basis to take legal action against a money manager who put him into investments that reduced his retirement account by $70,000 in 2010 — a year when most stocks posted strong gains.
When I asked what kind of investments he owned, he said, “They bought six or eight stocks and traded on the yen.” Regardless of whether he has cause for taking action, instead of owning six or eight stocks, he should have invested in hundreds or thousands of them, I explained. Unfortunately, he relied on a guy who said he knew which six or eight stocks (out of thousands) were going to rise the most. That’s not investing, that’s gambling.
Some people believe diversification isn’t necessary when you limit your investments to the biggest, best companies. But history shows that this notion simply doesn’t work. Remember Enron? It was the seventh-largest company in America when it filed for bankruptcy. The courts are littered with big-name companies that failed: General Motors, American Airlines, Chrysler, Lehman Brothers, to name just a few. Diversification protects you from losing a lot of money when your choices fail. This is why we believe that picking individual stocks just doesn’t make good financial sense.
Here are three examples of how you could be diverted from creating a properly diversified portfolio:
1. From July 2010 through March 2011, the price of cotton virtually doubled — the biggest increase since the Civil War. If you had invested $100,000 in cotton in July 2010, you would have had $200,000 eight months later. Hearing such news can cause people to eschew their lackluster investments (everything is lackluster compared to a 100% gain in eight months!) and throw money into this commodity before cotton prices rise even further. But you can guess what happened next: Cotton prices fell about 50%, according to EmergingTextiles.com. Those who bought at the peak lost half their money. It’s better to stay diversified.
2. Some people buy investments that reflect their opinions or beliefs. For example, they may refuse to invest in companies that are involved with tobacco, firearms or nuclear energy. Indeed, the best-performing mutual fund in 2010’s second quarter, according to The Wall Street Journal, was Virtus (Latin for virtue), a socially responsible fund. It earned 8.4% in that three-month period. But the second-best fund was the Vice Fund (formerly called the Sin Fund), which invests only in gambling, tobacco and alcohol stocks. And over the previous five years, Vice beat Virtue 3.4% to 3.3%. Instead of choosing between vicious and virtuous stocks, smart investors own them all.
3. According to the Labor Department, annual investment income earned by retirees has declined 34% since 2007, partly because retirees keep most (and often all) of their money in bank CDs, savings accounts, money-market funds, Treasuries and the like, where interest rates have dropped dramatically. By failing to maintain diversification (by keeping some of their money in stocks), many retirees have been forced to withdraw more of their principal for living expenses. In their effort to avoid stock-market volatility, their lack of diversification forced them to suffer reduced income and an increased risk of running out of money.
Being well diversified doesn’t guarantee any certain returns, of course. When a gentleman called my radio show to ask what return I could promise if he handed us $1 million to manage for him, I replied, “You’ll get a return comparable to the results produced by the global financial markets.” That’s what you can expect from a truly diversified portfolio.
I do use that word a lot, don’t I?
Editor’s note: Ric used the words diversify, diversified and diversification 16 times in this article.