Proper diversification is one of the single most important tools for any investor. Properly diversified investment portfolios are the best means of protecting and growing wealth. There are two main levels of diversification, at the asset level, and at the individual security level. Most people ought to own both stocks and bonds, as well as real estate, commodities, and cash. As well, folks ought to own some international stocks and bonds since a good portion of the world economy is outside the U.S. and investors can miss out on quite a few attractive investment opportunities by limiting themselves primarily to home country investments. (Home bias is a well known investor mistake that leads investors to put too much of their money in domestic assets and not enough elsewhere). And well-diversified portfolios should also have diversification within asset classes. Too much exposure to any one company, through its stock or bonds, is an unnecessary risk that is unjustified in most cases. A couple of real life examples can help investors to understand how risky it can be to invest too much in one single asset class or one security.
The first example is a case in which an individual sold his business and retired. His fee-based advisor (stockbroker) built a portfolio consisting of $2 million in stock mutual funds and $400k in private real estate investment trusts. The $2 million in stock mutual funds consisted of a large cap growth fund, large cap value fund, small cap fund, and an international fund (a pretty common allocation for the many sales guys passing themselves off as qualified investment advisors). Of course, all of the funds were front loaded and paid the sales guy a hefty 5.75% commission along with a 0.30% yearly trailing commission, and of course our poor investor was also paying 0.60% annually to the mutual fund to actually do the investing. The $400k in private REITs was split into two investments with the same company, with basically the same commercial real estate exposure in both.
So what kind of diversification did our poor investor get for all those commissions paid? Very little is the answer. The three U.S. stock mutual funds all performed equally badly during the 2007-2009 bear market and the international fund did even worse. The illiquid private REITS can't really be valued since our investor can't get out of those particular roach motels at the moment - the REITs are husbanding their capital and have suspended redemptions for the time being. The bottom line is our retired investor is busily looking to unretire now that his portfolio has dropped from $2.4 million to $1.2 million. Oh, and in case you are wondering why the sales guy put our investor in illiquid private rather than liquid public REITS the answer is.... BIGGER COMMISSIONS!
Our second case study highlights both types of unwarranted concentration. The fee-based advisor had put an older couple 100% in bonds (at the older couple's request), using both mutual funds and individual bonds. Additionally, the advisor had placed the majority of the money allocated to individual bonds in GE Capital bonds and California muni bonds. In fact, the GE capital bonds alone made up approximately 50% of the entire portfolio. Yikes!
There are a few observations worth making here. First, commission based advisors must sell something in order to make money. Like any good salesman they will keep trying until they find something their customer likes. Don't want mutual fund A? How about mutual fund B? Don't really want to own stocks? No problem, I'll sell you bonds (and take a juicy slice of the mark up). The moral of this story is that commission based advisors often sell what's easiest to sell rather than providing actual investment advice to the client (and risk losing the sale). There is no way a couple in their mid-60s with a 25 to 30 year planning horizon should be allowed to put 100% of their money in bonds - unless they have so much wealth that purchasing power risk (inflation) isn't going to bite them in the budget in the out years. And after Enron, WorldCom, Bear Stearns, Lehman Brothers, AIG, GM, Fannie Mae, and Freddie Mac, do I even need to talk about the incredible risk assumed by having some 50% of your bond portfolio in just one company? The fact is that our couple did dodge a bullet as the Federal Government did have to (quietly) bail out GE last year when the commercial paper market seized up.
Building properly diversified, low-cost, portfolios that will both preserve and grow an investor's wealth is a critical step in planning for retirement. Appropriate portfolios are not static in nature as they must change as an investor's needs change. Unfortunately, most financial advisors are paid to sell products and do not actually make their money from giving advice or investing on a client's behalf. Consequently, their motivation to sell frequently gets in the way of sound investment advice. It is no coincidence that both of our poorly constructed portfolios were put together by fee-based advisors. The fact is that it is a huge conflict of interest, which investors would be well advised to take into consideration when dealing with "the sales guy".
