What’s the purpose of diversification with regards to your investments? Why not just own companies you know well or stick with your employer’s stock? What other diversification strategies should be considered when creating a financial plan?
It’s important to understand why diversification matters with planning and investing. The reason to own different companies in your portfolio is owning one company over long periods of time may not get the job done in achieving your goals. Imagine if you simply owned one company stock. Let’s say its Disney stock because growing up as kid you visited the parks many times with your family and have a lot of positive memories. Now as an adult, you’ve taken your family back and perhaps even enjoyed a cruise on their ship. You know Disney, you like it, your family likes it, you decide to invest everything in one company. Seems straight forward and quite logical, right?
Structuring your portfolio around a single company has some limitations. You may only choose one industry, one size company, and one geographic location. This fails to include other companies that may add balance to your portfolio. Narrowing down your choices to a single stock may prove more difficult than you think. Which one do you choose and why? Once selected, this company may likely have large swings in value and may or may not pay dividends over decades. There must be an alternative.
Now consider another approach on the other side of the spectrum. Companies of all sizes, industries, and geographies in your portfolio. By owning more companies with different areas of focus you are gaining exposure to more possible growth opportunities. How might this work out?
All companies will expand and contract in value overtime often without reason or explanation. Some companies won’t make it while others will thrive and expand. When prices shrink or shoot to the moon it’s a smoother ride owning many as opposed to betting on one. A better approach includes owing thousands of companies ideally designed around a financial plan.
Exchange traded funds (ETFs) do this very effectively and are efficient by design. ETFs segment companies into different funds based on various demographics. There are large US based companies, medium sized, and small, all in their own fund. The same holds true for non-US based companies. Beyond size and location, there are funds that specialize in companies that work solely in financials, health care, energy, and technology.
One thing that has not changed, with one company or many, is who’s running them. All companies are operated by smart men and women and often accountable to a board of directors. This provides oversight and direction for the good of the shareholder. Real people continue to be the ingredients that makes a good company great. That seems overlooked today as it’s easy to view a large corporate entity without considering the people who are doing the work. This is also where familiarity bias comes in when selecting companies to invest in. We are more inclined to pick companies we know well, such as Disney or our employer’s stock versus creating a diversified portfolio. Owning ones, we know well without including other choices may put our long-term plan at risk. When your choices are restricted to a single company or a dozen in your portfolio, you lose diversification. It then becomes less about planning and strategy and more about short term earnings, growth, and rates of return now. This turns the focus in the wrong direction and often leads to costly mistakes. These same mistakes may also take place when owing ETFs. Focusing exclusively on a particular geography or industry without including others does not work. If all the ETFs you own are US based companies or all foreign technology stocks, you’re not diversified.
The challenge for investors is creating a portfolio that best matches their goals. This requires that you have goal clarity and the time and energy to create a portfolio that supports your goal. This tends to be much more difficult to accomplish on your own, so often hiring a financial professional may make sense. With goal clarification completed, a portfolio may be constructed holding the correct percentages of various companies. This is diversification at work. At Flowerstone Financial, we create an investment policy statement for every portfolio we manage. This is a document that spells out what you own and why and provides direction around what you invest in. Managing this portfolio of companies and rebalancing it back to its intended percentages takes process and a plan. Often when acting alone, our emotions may get the best of us and fear may take over. A financial planner is there not to increase portfolio outcomes but rather to be an accountability measure. This helps you stay the course and focus your investments on a date specific duration specific plan. Human nature being what it is, it’s easy to react and mess up the portfolio when uncertainty is present. When this happens, the plan may begin to sink as goals are pushed out further into the future or become unachievable.
Do you remember the following companies, Radio Shack, Pan Am Airlines, Blockbuster video, and my all-time favorite, Pets.com? I vividly remember beginning my career in the mid-1990s and discussing diversification with prospective clients. This was met with a large smile and the following response. “Ryan, I just invested on my own in pets.com and I’m making a killing! Why, would I diversify as prices continue to rise and my account is getting bigger? More is better, right? That’s the point of investing, more money! At this pace I will definitely retire before 50! Thanks, but no thanks, I’m doing great on my own.” Fantastic, I thought to myself, I’m competing against a sock puppet on TV who has captured the investor’s attention! Well, fast forward to the year 2000 and we all know how that story ended along with hundreds of others. You diversify so that you don’t end up owning enough of one company to make a killing or get killed. Prudence, patience, and diversification with a financial plan matter in the long run.
Diversification is not just limited to companies, cash diversification matter as well. Cash is cash, right? Cash diversification has more to do with location and the purpose it serves. Avoiding the normal behavioral tendencies to keep all your cash in your checking or savings account is not easy. Co-mingling cash that will address home improvements, the kid’s braces, a big-ticket purchase, and buying groceries may create conflicts. Which priority is most important? It depends on timing and what’s needed now. When cash is not diversified into separate accounts, our brain works hard to mentally account for how it may be best used. This is where mistakes happen as it’s impossible to track all our financial decisions in an orderly process in our head. An easier solution is to establish cash accounts with various job descriptions, so you have enough in the correct account when you need it. An operational account for bills and general spending, home and travel account, and a cash reserve account may get the job done. It really depends on your plan and how you intend to spend your cash.
Tax diversification also matters. Selecting different tax environments to grow your investments will lead to different taxes paid when you call upon your money. One day, you’ll want to remove these dollars from your investment accounts for income, a trip, or something else important. How will taxes impact your decision? Participating in a pretax retirement plan, after tax investment account, and a Roth 401k/TSP will provide more choices then having your entire investment portfolio in a pretax environment. Factor in that most Social Security benefits will be taxed when received and this may further inflate your tax bracket before you withdraw a single dollar for income. Yes, tax reform takes place every number of years and it’s anyone’s guess where it will go next. The point of tax diversification is owning investments in different tax environments that will support your plan and provide more possibilities and choices.
Investment, cash, and tax diversification all play a large role in building wealth. It’s never too late to get started or make a change in how you are directing your money now. Change is not easy, but neither is living with uncertainty on where you are headed. If you’d like to chat about your goals and define what’s possible, we’d be happy to listen and see if we might help.