Focus on and take control of your retirement (Photo credit: s_falkow)
The following post is by staff writer Teacher Man, who writes at My University Money.
The financial industry makes a mint of throwing buzzwords as people that are financially illiterate. How many times do we see financial planners throw around the term “diversification” as if it were not merely one of the Ten Commandments, but first on the list? Diversification is definitely important, but if you’re not really sure what it means, it can be used to justify selling almost anything.
“Hey, does your portfolio include any emerging markets? Better grab this mutual fund for international diversification.”
“The Canadian market is hot this year, we’ve got a 5-star fund to cover the entire sector and it makes sure you’re well-diversified.”
“I would recommend you diversify your holdings with a fund that focuses on growth stocks.”
Sound familiar? That’s because most mutual fund salesman financial planners get paid a commission to sell certain mutual funds regardless of what is already in someone’s portfolio. Often, people who have been saving for years and “buying RRSPs” (a pet peeve of mine is when people say they are going to buy a RRSP… It’s not a financial product people, the P stands for plan) from the same company every year. When you look at what their money is actually invested in, they are inevitably buying the same companies over and over again under different mutual funds and recommendations.
A Kernel of Truth
Diversification is important if you are picking single stocks. This is where the “common sense knowledge” comes from. You obviously don’t want to “Put all your eggs in one basket.” Don’t invest in only mining companies, or go all in on a certain technology stock for example. Where most people should look at diversifying, is actually in the department of asset allocation. Once you decide the amount of your investments that you want tied up in equities, the rest should be pretty straightforward. If you’re a young investor, getting into a mutual fund that is 60% bonds is probably not in your best interest in terms of investing time horizon. If you’re approaching retirement and have a low risk tolerance, being convinced to go with a 100% growth equities fund is probably not a good idea. Once you talk to a fee-only planner and determine your asset allocation, the actual exposure to equities is actually very easy to take care of, and it doesn’t cost a lot of money to meet the magical standard of “being sufficiently diversified.”
Buy American? What Does That Even Mean Anymore?
When you actually look at the makeup of international conglomerates today, the whole idea of needing a lot of stocks is almost a joke. There are holding companies out there such as Power Corp for Canadians, or the famous Berkshire Hathaway of Warren Buffett, that allow you to efficiently invest in companies from a broad range of sectors, that sell products all over the planet. Companies like Coca-Cola, Johnson and Johnson, or the Royal Bank of Canada have holdings all over the world, and are so geographically diversified that an issue in one part of the world barely dents their overall financial position. Most buy-and-hold investors that I follow often find that between 20-30 stocks (and sometimes as few as 8-10) are easily enough diversification to suit their tastes. After all, why do you need 5 gold companies if they all depend on the price of gold anyway?
Passive Investing
I have little faith in my personal ability to pick the right individual stocks. For this reason, I am definitely a fan of ETF investing. It is the easiest way to diversify your holdings quickly and efficiently. One interesting thing that I have seen lately, is that even so-called advocates of ETF investing can over diversify. I think that 5-7 ETFs should be the absolute maximum that you need in order to effectively track the world’s stock markets. I’ve seen people that jump on every new ETF that comes out, and doing this merely makes their finances more complicated, and less efficient if one is paying a higher MER than they have to be.
To be brutally honest, investors that merely focus on making smart financial decisions, properly determine their asset allocation, and just buy an ETF like the Vanguard S&P 500 ETF (VOO) over and over again, will probably do better than 90%+ of investors out there. When you really consider that those 500 massive companies that make up the index are really only American companies in the sense that, that is where their headquarters are, then it becomes pretty apparent most investors would be fine just keeping it simple a broad-based ETF such as that one. As a bonus, it costs almost nothing to own (an MER of .06%) and many brokerages are beginning to offer commission-free ETFs at this point as well, which makes it even more cost-efficient.
Don’t try to outsmart yourself this investment season. Take a look at what your portfolio is really trying to accomplish, determine if it’s geared toward your investment goals, and then decided just how much you should be willing to pay for the “magic” of diversification.
While I do think some diversification is definitely needed it seems like a lot of people go overboard with it. I like more of the Buffet approach where he stated he picks a few great companies and rides them.
While there are a lot of good advisers out there many are looking to make commissions so they want you moving and buying too frequently.
Buffet’s strategy is great if you are as smart and talented at allocating capital as he is. I’m not ready to take on that mantle, if you are, you should be making way more money and paying someone to comment on blogs!
I think part of the problem is we are all looking for that quick fix and it should last or stay forever. An asset allocation is a work in progress. That is it is tweaked once a year forever. How many people feel comfortable doing that? Too many (non PF bloggers) feel very uncomfortable with all the PF information and they do not want to spend the time. They just want the quick fix.
Definitely. Too often the mutual fund industry is all too happy to take advantage of this “quick fix” mentality. Commissions and fees anyone?
I think a lot of people fall into the over-diversification trap because they don’t realize how much things overlap. I like using Morningstar’s fund screener to really show you what holding and funds overlap.
Morningstar’s fund screen is a cool tool, as long as you completely ignore their star ratings (a better example of “past performance is not a strong indicator of future results” cannot be found).
The more diversified you are, the more your portfolio becomes correlated with an index fund, so why not just buy the index fund and save on the expense ratios.
I couldn’t agree more; however, some people actually own more than one ETF or index fund that cover the same companies.
A great tool to use is to put your portfolio through some x ray or overlapping software. Essentially because different mutual funds have all kinds of fancy names, this software will make sure you aren’t buying the same thing in two supposedly different funds. I am a big thumbs up to using low cost etfs
Ted Jenkin, CFP®, AWMA®, CRPC®, AAMS®, CMFC®, CRPS®
Co-CEO and Founder
oXYGen Financial, Inc.
Loved what krantcents said.
Investing is not a quick fix. Trading is 🙂
Regarding your comment: “I have little faith in my personal ability to pick the right individual stocks. For this reason, I am definitely a fan of ETF investing.”
I think this is great, but I don’t think it’s that hard to pick stocks.
Own what the big ETFs own, but only the established dividend-paying stocks. Look at VTI, the top holdings that are established dividend payers:
Exxon Mobil Corp.
International Business Machines Corp.
Chevron Corp.
Microsoft Corp.
General Electric Co.
Procter & Gamble Co.
Johnson & Johnson
AT&T Inc.
Pfizer Inc.
Coca-Cola Co.
If those companies aren’t making money in the U.S., that economy is toast and so is your ETF.
Thoughts?
Hey Mark, take a look at my post over on Dividend Ninja are if you want my thoughts. Perhaps picking good companies is not hard (they are likely big and successful for a reason) but picking them at the right time is. Plus, when you only invest in those big companies, you lose the superior return of the small-cap asset class.
TM – Nice post. I agree with your last part the most. Buying a low cost ETF or mutual fund WILL probably do better than 90% of active funds or people trying to pick their own stocks. Unless you know something the rest of us don’t, there’s really no quick way to get rich in the market.
If you want to read 45 pages of why this almost assuredly correct, head on over to my site and download my eBook on ETF Investing.
I agree that mutual fund salesman normally don’t even want to tell you how bond funds work, much less recommending it to you as part of your asset diversification strategy. If any financial advisor mention this to me (things like you should have (100 – current age)% of bonds in your portfolio), I’ll be quite impressed because he at least take your portfolio into consideration, not only his big fat commission.
Also, I think it’s okay to put your eggs in one basket (or 2 or even 3), but just watch the baskets closely 🙂
That is how people tend to get rich quick (or lost capital quick). Just pray one of your eggs doesn’t get smashed! It’s not for me.
I definitely agree with the term “diversification” being thrown out there wayyyyy more than it is needed.
I do think you should have a litte more faith in your ability to pick stocks. Have you done so in the past and have had more bad than good come of it?
Taline, here are some stats for you:
In an extensive Dalbar study from 1990-2010 the stock market returned 9.1% on average. My boring ETFs would have returned me about 8.9%. The AVERAGE American investor received returns of 3.8%. Also, roughly 90% of professional money managers can’t even pick stocks, why do I think I am smarter than these people? When you pick stocks you are competing against some of the smartest people in the world. Many of whom have built-in structural advantages. Check out my new eBook for a more detailed explanation.
Interesting concept, that people can over diversify. Or, maybe another way to look at it is spend too much time and effort trying to diversify.
Really, I agree with the concept of simplification. Index funds and asset allocation can do much of this with less work and lower fees than trying to get complicated and outsmart oneself.
Preach it brotha!
The danger is not over-diversification but overpaying. Any investment choice that charges above, say, 0.6% annual expense ratio is terrible right off the bat, regardless of what it invests in. Any investment that charges over 0.3% annual ER can still probably be safely omitted in favor of cheaper ones. It’s all about controlling costs.
I absolutely agree simply holding VOO as the only equity holding is easily better than 90%, if not 99%, of what the “advisors” and other “experts” will steer you towards. The reason why VOO is better is not its great diversification (it’s good but not great) but it’s rock-bottom 0.06% annual expense fee.
I think it’s great for us Canadians that Vanguard finally has some products on the TSX. I’m curious as to what the overall impact is versus buying their US-based ETFs. Now what we really need is for their mutual funds to enter the market so we can turn up the heat on the traditional providers. MERs of 2% and up are just completely unjustified, and it’s almost a crime for financial planners to be peddling and pushing these onto consumers.
Great post, Teacher Man, and I don’t mind you pitching the eBook either. 😉
I am a big fan of ETF’s. The S&P is my choice. Simple and like you said, will most likely beat 90% of investors. I do enjoy in buying and selling a few choice stocks. I try and remain patient with them. I buy when it goes down, and sell when it goes up. I pick targets and try and stay dedicated to them. I have been pretty happy with the results.
Great points about over-diversification. I own just three ETFs. And it’s sooo easy to manage.