Show Notes
Having a well-diversified portfolio is one of the main goals of most investment strategies. Although few would argue with this, the reality is that many investors eventually lose sight of why diversification was implemented in the first place.
This episode illustrates, with vivid examples, how investors might say they want something, but what they actually do completely contradicts their stated desire.
Jeff Harrell also addresses whether there is any scenario in which it makes sense to ignore diversification. And he shares some insider’s knowledge about something financial service firms call “window dressing”… you’ll want to hear this.
If you were under the impression “playing Monday morning quarterback” was reserved for sports and political conversations, think again. You’ll learn just how bad investors are at second-guessing their actions when those decisions don’t work out exactly the way they thought they would.
(Season 2 Episode 2)
Other Episode Referenced:
Podcast produced by Ted Cragg of QuickEditPodcasts.com
Music Credit: Dream Cave / Adventure Awaits / courtesy of www.epidemicsound.com
Transcript
Diversification is an investment term that almost everyone is familiar with. It’s pretty much the first topic anyone who gives financial advice will bring up when they start providing specific investment recommendations. Most people nod their heads and agree that owning multiple investments is a good idea. In fact, I never once met with a client who disagreed that some diversification was a good idea when our relationship began. However, as time goes on, this perception often changes. And what I have seen over the years is those who fail to understand the real benefit, eventually tend to prefer concentration to diversification.
Welcome to the second season of Invested Poorly: Sad Tales of FInancial Fails, a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.
Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with show.
Having a well-diversified portfolio is often the core strategy of a long-term investment plan. This means that not only do you have a number of different investments, but most importantly, that those investments have a low correlation to one another. In non-financial jargon terms, this simply means they don’t go up and down in a similar fashion to each other. Unfortunately, as relatively easy as this concept is to understand, the real purpose of diversification is very often misunderstood. That’s because a lot of people think the main goal of investing is to achieve the highest return possible, and while that may sound good on the surface, in reality, the goal of diversification is to reduce risk, not maximize your return.
Now, before I get into my stories, let me walk you through how the beginning of an investment advisory relationship works. First, the advisor gives the client some type of risk tolerance test to determine how comfortable they are with investment volatility. After this, the advisor looks at the various types of accounts they have and what their financial goals are for different time periods. Other factors, such as their savings rate, current and future expenses, family obligations or inheritance are also considered along with a host of other variables. Eventually, all of this culminates into a recommended investment strategy that attempts to optimize all of these factors, resulting in a diversified portfolio.
Like I said at the beginning, at this stage, I never had a client question the validity of this process and only rarely would I get questions about the specific investments we were recommending.
Now let’s fast forward a year or two. While I’m definitely not going to suggest that what I’m about to say represents an overwhelming majority of investors, I do think many of my clients began to question the benefits of diversification shortly after our relationship began. And the reason for that is because by design, diversification will lead to one or two investments that materially underperform some of your other investments. So, despite the fact this is guaranteed to happen from the outset, many investors start second guessing the strategy. Almost inevitably they question why they purchased the underperforming asset in the first place and often want to get rid of it and buy more of what has been doing the best.
These conversations were so frustrating. It was like the client expected me to know in advance which asset was going to underperform and only invest in the best performing one. Obviously if I knew in advance with 100% certainty what stocks or investments would do the best, I would only invest in those. But I don’t. Nor does any other investment professional have the ability to predict which investments will always perform best. So, I hope by explaining it this way you will have a better understanding of why this type of thinking makes no sense. For more stories highlighting the futility of trying to predict the stock market, check out Episode 9 of Season 1, which is linked in the show notes.
Now, the financial services industry is well-aware of this naïve thought process, which is why there is a term to describe how they address it: “Window Dressing.” Which is basically the act of selling an underperforming investment, not because they actually think it’s in the client’s best interest, but instead because they simply don’t want to talk about it anymore. I can verify that the longer you keep the underperforming investment in the account, the more questions you get from the client. So instead of explaining why the investment remains in the account, which by the way, is almost always for diversification purposes, the investment is simply sold and something else is purchased. That is window dressing.
What this strategy eventually leads to is a less and less diversified portfolio. And while I’m not going to lie that sometimes this can work out in your favor; from a risk management standpoint this is the wrong thing to do. One of my best examples was a client who was saving for their child’s education. Their previous advisor had recommended a diversified portfolio of stocks and bonds, which I felt was appropriate given she was going to have to start withdrawing from the account the following year. I remember telling her I would just keep the account as is and slowly deplete it over the next four to five years. However, she was not very happy with the return of the bond funds, so she decided on her own to sell all of these and invest the entire account in the stock market.
You can probably guess where I’m going with this. Yep, the stock market hit a rough patch less than six months before her child was going to college and the account dropped significantly right when she started to need the money. Her failure to understand the importance of risk management cost her tens of thousands of extra dollars she had to come up with to send her child to college.
I have other stories similar to this of investors who ignored diversification in favor of concentration and paid a heavy price. I remember meeting a doctor at a conference once who couldn’t stop bragging about how well her retirement plan was doing. She had it invested entirely in one stock, a Chinese electrical vehicle maker. This was one of those “nodding my head” moments where I just pat the person on the back, stroking their ego as the greatest investor in the history of the world to make them feel really good. Well, over the next couple of months I couldn’t help but keep an eye on the stock. I’m honestly not sure what happened, but I do remember looking it up one day only to notice the stock had dropped over 80%. In fairness, I have no idea whether or not the doctor sold before the big drop, but what do you think? My guess is probably not.
So, before I conclude this episode, I’m going to make one HUGE contradictory statement. And that is, under the right circumstances, ignoring diversification can make a ton of sense. In my opinion, the one scenario where it does make sense to consider concentration over diversification is when you are young and have a relatively low net worth. The reason I like to always mention this is because during my career as a financial advisor, the only portfolios I ever came across where I truly believed the investor had materially outperformed a broad-based stock market index like the S&P 500 was when they had a very large position in a stock like Apple or Microsoft. Every time I saw this, I knew this was something they had held onto for years.
Using those stocks as examples, I think it is important to recognize that one of the biggest benefits of investing in stocks is that while losing 100% in any stock is always a possibility, on the flip side the potential gain is unlimited. So if you want to dabble with individual stocks when you are in your early stages of investing, be my guest. Even if you buy a couple that go bust, it’s ok because if you manage to hit the next Apple or Microsoft, ten years from now, this will more than make up for the losers.
Now, as you approach FI and have a larger portfolio, risk management via diversification should become more important than maximizing your return. But until then, investing in a stock or two that you think might be the next big thing is not something I would talk you out of.
So I just want to leave you with one final reminder. Diversification is NOT an investment strategy designed to maximize your return; it is intended to minimize risk. I hope this episode helps to clarify that and leads to a better understanding of how to evaluate your investment portfolio.
I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.
Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen”! So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.
I’m your host, Jeff Harrell. Thanks for listening.
Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results.
This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.