Cornerstone

Wrong Kind of Diversification

What is “diworsification”? The aforementioned word and its definition cannot be found in the Webster’s dictionary. Still, many investors may be “diworsifying” their portfolio by adding investments and/or advisors that ultimately result in increasing the risk of their portfolio.

Probably the most common diversification error made by individual investors is purchasing several different mutual funds that invest in the same asset class. Owning five different U.S. large-cap growth funds provides only minimal diversification benefit. In this case, all the funds would be invested in the same basket and exposed to the same types of risks.

Investors may make a similar error when deciding who will manage the assets in their portfolio. Not wanting to have all their eggs in one basket, some investors hire several investment advisor firms. This is a mistake on two fronts. First, academic research indicates that almost all of a portfolio’s risk is determined by asset allocation and not by the number of advisors.

Second, hiring multiple advisors can create several problems:
 Most people want to simplify their life, not complicate it. Working with multiple advisors complicates the portfolio’s management.
 Economies of scale can be lost. Advisors who charge by the amount of assets under management typically charge lower fees on larger portfolios. Investors who split their assets among several different managers may miss out on such a benefit.
 Holdings may be duplicated, both in terms of individual stocks and asset class exposure. Thus, the portfolio may not be effectively diversified and may be more risky.
 If each advisor operates independently, there is the potential for inefficient tax management.
 If each advisor operates independently, the portfolio’s desired asset allocation may not be maintained.
 
Having several advisors not only creates difficulties on the investment front, but could create other problems as well. Consider that it is not enough to have a well-developed investment plan. For example, it is also necessary to have the discipline to adhere to the plan, including regularly rebalancing the portfolio.

Therefore, a prudent approach would be to integrate an investment plan into a carefully constructed estate, tax and risk management plan because investment decisions and performance can impact other areas of the plan and vice versa.

You should have a qualified financial wealth manager serve as the quarterback of your financial services team to ensure you have the greatest chance of achieving your financial goals. That person should be responsible for coordinating asset allocation and estate, tax management and risk management plans. And he or she should make the appropriate adjustments as your personal circumstances change.

You should seek a relationship in which you are comfortable disclosing all of your investment accounts (such as IRAs and 401(k) accounts), all of your financial assets (such as stock options and life insurance) and all of your financial and estate planning decisions to your financial quarterback. That is the only way you can be sure that your plan is a well-integrated one. It will also allow you to avoid duplicating holdings, minimize asset allocation drift and ensure that the asset location decisions are correct.

Summary

While diversification is part of a prudent investment strategy, some kinds of diversification are more effective than others. Hiring multiple investment advisors creates the potential for inefficient portfolio management, and it may add unwanted complexity to your life while increasing costs.

There are simple steps you can take to eliminate the need for multiple advisors, including hiring an advisor that:
 Adopts a passive investment strategy
 Operates an open platform (doesn’t sell proprietary products)
 Provides both investment management and wealth management services
 Provides a fiduciary (not suitability) standard of care

Hiring a qualified and trusted financial quarterback will not only provide you the best chance of achieving your financial goals, but it will also simplify your life — two worthy objectives.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2007, Cornerstone Wealth Advisors, LLC.

Confusing the Familiar with the Safe

Peter Lynch, a legendary investor, authored the book One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. However, too many investors follow Lynch’s advice to buy what they know. Doing so causes them to make the investment mistake of confusing the familiar with the safe.

An example of “familiarity breeding investment” comes from a working paper by Gur Huberman, who cited Georgia residents and their ownership of Coca-Cola stock. At one point, residents of the Peach State owned 16% of all Coca-Cola stock, despite making up less than 3% of the U.S. population. Since it is no safer to own Coca-Cola stock if you live in Georgia than it is if you live in Missouri, the only logical explanation is that Coke’s headquarters are in Atlanta. And why did people in Rochester, NY tend to own a disproportionate share of stock in Kodak and Xerox? Both have large operations in Rochester.

It’s likely that many St. Louisans are following similar patterns. Some might own disproportionate shares of local companies, such as Anheuser-Busch, Ralston and Monsanto. Despite the outstanding returns generated by the market in 2006, we were provided with many reminders of the dangers of confusing the familiar with the safe.

According to the St. Louis Post-Dispatch, of the 54 companies included in a list of St. Louis major-index stocks, 21 (or 39%) generated negative returns. Of those 21 companies, 13 produced double-digit losses. Four produced losses of between 20% and 30%, two had losses of between 30% and 40%, one had a loss of 41% and one with a whopping loss of 77%.

Compensated Versus Uncompensated Risk

There are two types of financial risk: those that can be diversified away and those that cannot. Among the risks that can be diversified away are those that come from attempts to pick winning stocks. Investors are not compensated for taking these individual-stock risks that can be diversified away. In other words, although the expected returns from a stock-picking approach are no greater than broadly investing in equities, the risk is significantly greater when one’s holdings are concentrated in fewer securities. And that’s before one considers the expenses of implementing the approach.

In 2006, employees of the following companies learned that just because you work for a company and are familiar with it, doesn’t mean it is a safe investment.

COMPANY                             CHANGE
Revlon                                  –57%
Vonage                                 –53%
Whole Foods                         –39%
Yahoo                                   –35%
Cheesecake Factory               –34%
Six Flags                               –32%
eBay                                     –30%
Boston Scientific                   –30%
Red Robin                             –30%
Williams-Sonoma                   –27%
Arch Coal                              -25%
Intel*                                    –19%
*Worst performing stock in the Dow Jones Industrial Average Summary

Gary Belsky and Thomas Gilovich, authors of Why Smart People Make Big Money Mistakes — And How to Correct Them, warned investors to avoid confusing familiarity with knowledge: “For every example of a person who made money on an investment because she used a company’s product or understood its strategy, we can give you five instances where such knowledge was insufficient to justify the investment.”

Prudent investors take only risks for which they are compensated. The prudent strategy, therefore, is to use low-cost, passively managed funds because they are efficient ways to build a globally diversified portfolio, and help to eliminate uncompensated risk.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2007, Buckingham Family of Financial Services.