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Diversify, diversify, diversify—it can’t be said enough. History has
shown us, very recently in fact, how vital it is to diversify our investments.
When a stock, mutual fund, or even a sector is hot, it can be
tempting to think about investing a good portion, or all, of your
money in it. However, this is the riskiest thing you can do. Smart
investors know that in order to make consistent positive returns over
the long run, your portfolio must reflect different types of investments
and different sectors.
I have many clients who came to me with large holdings in their
companys’ stocks. It’s very easy to accumulate a lot of stock in the
company for which you work. Many companies only give their
401(k) match in company stock. It’s then up to the client to diversify
that stock across different funds within his or her 401(k). I personally
caution my clients about holding more than 5–10 percent in one
stock or holding, although diversification alone is no guarantee that
the overall return will be profitable.
One client of mine works at Johnson Controls. The company’s
stock has done reasonably well over the past year or so, and my client
had amassed a 401(k) worth more than $1,300,000. She watched the
stock prices daily and was actively managing it herself. However, the
entire amount was invested in Johnson Controls stock. This meant
that whenever the stock price dropped even a little bit, her portfolio
took a hit.
When we first met, she explained to me that she felt very comfortable
leaving her money in Johnson Controls because she worked
for the company, watched the stock price every day, and was confident
that her 401(k) was stable. I discussed the importance of diversification
with her. As is the case with every meeting, I left CNBC on
so that I could stay constantly informed about what’s going on in the
market. During our meeting, a trade for Johnson Controls came
across the bottom of the screen; it showed the stock down by a few
cents. Now, a few cents is not a big deal when the stock price is as
high as Johnson Controls was at the time. However, my client’s entire
401(k) had just dropped noticeably during our meeting. I used this as
reinforcement of my point about diversification.
At our next meeting, my client brought her husband in with her.
She was still keeping her money in the Johnson Controls stock,
which I again told her she should reconsider. I discovered that I had
a very strong ally in this: her husband. He was very nervous about the
fact that everything was in one stock. Though she wasn’t convinced
to diversify totally, leaving only a small portion of money in Johnson
Controls stock, she did move a portion of her 401(k) to different
funds within her retirement plan. At our subsequent meeting, both
she and her husband confided that they felt much more comfortable
having money spread across different asset classes, rather than in just
one stock.
Another client came to me recently because he was having problems
with his 401(k). He had retired two years earlier and had rolled
his 401(k) into an Individual Retirement Arrangement at an investment
firm. He was now self-directing his retirement money. When he
retired in 1998, his 401(k) totaled nearly $1 million. Following the
advice of friends, as well as his own research, he spread the whole
amount over five different individual stocks and one mutual fund. By
the time he came to see me, his accounts were nearly $350,000.
When we met, he was just sick with anguish. Not only had his
accounts lost more than half their original value, but also he hadn’t
told anyone about this. His entire family still thought there was close
to $1 million. He also told me that a few of his friends (already
clients of mine) had recommended coming to see me when he retired,
but he thought that he would be able to manage his money better. He
believed, as I’m sure many do, that since he cared more about his
money, he would do a better job.
The mutual fund he had picked was a highly sectorized fund that
had performed poorly. While other mutual funds were making
money during 1998 and 1999, this fund had continued to lose value
and underperform. The stocks he picked fared poorly as well. Two
were health care stocks, two were Internet stocks, and the fifth was a
small cap stock. All the stocks were valued at less than $3 when we
met.
He knew that he needed to do something, but was so upset that he
didn’t know what. Together we discussed diversifying his portfolio to
help stabilize it. I put together a financial plan for him and showed
him the different asset classes that were recommended. We were able
to liquidate a couple of the stocks he held, as well as the mutual fund.
We then invested the proceeds across different sectors, including
international stock funds, high- and low-grade bond funds, and large
company stock funds. Fortunately, we were able to preserve a lot of
what remained. However, we had to keep some of the stocks he held
because there wasn’t a big market for them. We are continuing to sell
these off over time, as they continue to make the value of the portfolio
jump around wildly.
Diversification into international funds may also be suitable for
you. We have become a global-based economy, with countries
becoming very connected. Staying invested in just one economy also
remains risky. Each of the world’s largest markets has experienced a
decline of 30 percent or more over the past two decades. Most
notably has been the fall of the Japanese market. In just 10 years, the
Nikkei dropped from 38,915 in December of 1989 to 13,406 in September
of 1998. In July of 2001, it hit 11,609, its lowest point since
January of 1985. Being invested in just the Japanese market would
have spelled doom for that investor.
Likewise, I try to make sure that each of my clients has some sort
of fixed investment that helps stabilize the portfolio when the overall
market is down. While diversification won’t totally protect a client’s
portfolio from losses when the market is down, it will help preserve
most of the portfolio’s value. After analyzing a client’s current holdings,
time frame, goals, and comfort level, I will recommend one or
more investments that I believe will help them. In the past, I have recommended
fixed annuities, which grow at a certain rate of interest
and aren’t subject to market fluctuations; money market funds,
which don’t vary with the market; or real estate investment trusts,
which pay the client quarterly dividends.
One last point about diversification: beware of overlapping individual
securities within different mutual funds. You may feel that you
want to stay as light in the technology sector as possible, and think
that you are invested in mutual funds accordingly. Ask your advisor
to do some research to make sure that is the case. Many funds invest
in the same, or similar, individual stocks, thus making your portfolio
heavier in certain sectors than you may want it to be. |
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