In this month’s edition of “Money Matters,” Scott discusses the importance of diversifying your investment portfolio for long-term financial success.

Money Matters: Investment Diversification Transcript

0:00:00.1 Mark: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He's taught hundreds of financial professionals about retirement planning and wealth management strategies. Scott joins us now by phone. Welcome, Scott.

0:00:23.6 Scott Oeth: Hey, good morning, Mark.

0:00:25.1 Mark: Alright. So I've heard often this line that you should make sure that you diversify your portfolio. What is that about? What is diversification all about?

0:00:38.2 SO: Yes. It is a very important topic, and it is an age-old concept. So I'm certain you have heard it before. In fact, I was just refreshing myself thinking about this topic, I found out that over 2000 years ago, in the Talmud, it was written, "Let every man divide his money into three parts; Invest one third in land, one third in business, and keep one third in reserve." That is the basic, spreading the risk. You've heard the concept of, "Don't put all your eggs in one basket." And we know that we wanna have our money work for us and work for us over time, and that can be very powerful. But to avoid ruin, we wanna be careful about spreading the risk.

0:01:23.0 Mark: Alright. So when you say to prevent ruin, so that means if you have all your funds in gold or something like that, and the price of gold goes down and you lose everything, well, that's a problem. Maybe you should have had it invested some place else as well. So what are other areas?

0:01:42.6 SO: Yeah. A big thing here with the risk is, there are different types of risk, okay? There is the type of risk that an investment can go under or seriously under-perform, and so we can think of a lot of big headlines, Enron is a famous one. Six years in a row, Fortune magazine named Enron the most innovative company in America. They named it the most admired company in America. And then it went down in a famous blow-up of corporate scandal and became a poster child for corporate greed. So that was a while ago. But Sears. This was one of the most dominant companies in America. Kmart, these were the retail icons as I was growing up. And when I was studying investing in business school, 30 years ago, 25 years ago, we were doing case studies on Sears and General Electric. And GE is in big trouble now. So even companies that seem like they're at the top can suffer a great fall later.

0:02:46.7 SO: So there's a risk of being too concentrated in one company, but even if you spread out to larger baskets, again, thinking back to when I was in college, studying this as a finance major, we studied Japanese management techniques, we studied just-in-time inventory system. I clearly remember professors telling us one of the best things we could do is learn Japanese. And Japan, as an investment case, went flat for about the next 20 years. The S&P 500 is probably one of the most widely followed indexes we see today. It's on the nightly news, it's in the headlines, what has the S&P 500 done. And it is a basket of 500 of the biggest US company stocks, and in general, it turns in very good investment returns over time, but not all the time. The 2000s were considered a lost decade, where the S&P 500 was essentially flat, investment return-wise. And we've set the back ups to the 1970s, there was the same story. It was almost flat for large company stocks. So we wanna spread the risk of anything really bad happening to our investments, and we also wanna spread because we wanna be able to capture different pockets of return.

0:04:00.4 Mark: Now, what we've been talking about so far, when you talk about diversification is like diversification within the markets and within the stock market and things like that. What are some of the downsides of diversification and how does it affect those investment returns?

0:04:17.1 SO: Yeah. Well, what happens is, if you're sitting here today with what most investment professionals would consider a well-diversified portfolio, so even if it's a growth-type portfolio, you probably have some bonds, you probably have some international stocks, you probably have a bit of real estate, and you're probably scratching your head saying, "Hmm, I'm under-performing. Why aren't I getting the returns that, say, the S&P 500 is turning in right now?" So it's... As one of my partners at the office likes to say, "Diversification works whether you want it to or not." And so it works over time and it works well over time. It doesn't seem to work every time. So in the short run, there'll be periods of time where it seems that one investment category or one cluster of stocks is clearly outperforming. But what we know, there's a wonky finance term called variance drain.

0:05:12.8 SO: And it reminds me, about 10 years ago, Mark, I took a wonderful fall hiking trip in Northern Minnesota, and I had a friend who had a young golden retriever with him. And we probably hiked about five miles that day. Wonderful, through a canopy of yellow birch and aspen and crisp air coming off Lake Superior. That golden probably went about 15 miles. It had zig-zagged all over the course, back and forth, off the trail, chasing rabbits and sniffing for grouse and things like that. And it was a great day, but we ended up in the same place. But that golden, it easily went three times as far as we did. And we know this concept of variance drain, that if we have two stocks or two portfolios, and one portfolio, even if they end up in the same place, the portfolio with the smoother ride will actually generate more dollars and real wealth.

0:06:02.8 SO: So back to your question, in a year like now, or many years, it often seems that one investment category is outperforming the diversified portfolio, but over time, the more consistent returns have the potential to generate more wealth.

0:06:19.1 Mark: Now, going back to the Talmud, which I love that... I love that expression. I need you to say it again actually too. So diversification, it's not just about what kind of money you're investing in the market, or your money market things, or things like that, isn't it also about property and other things like that too?

0:06:38.2 SO: Yeah, I think that makes a lot of sense. I am very much a proponent of looking at the total person, your entire balance sheet and even beyond financial aspect, so absolutely, it makes sense to not just look at within stocks and bonds, but to think about things like real estate or your own business interests but, well, I think there's a whole lot of thinking about investing in your career, in investing in relationships, investing in health, all these things add up to your overall well-being and your sense of achievement, accomplishment, satisfaction where you're at in life. So yeah, absolutely. Not just numbers on paper and stocks and bonds.

0:07:17.0 Mark: I really appreciate you clearing that up for me because investing so often I just think about the market or something, but no, investing is investing in other things in your life too, to bring some balance. Okay, any other diversification issues that you want to talk about today, Scott?

0:07:36.4 SO: Well, I just think as we sit here today, it's been an interesting year, as everyone likes to say 2020, the S&P 500 index that I mentioned earlier is hitting all-time highs, but it's not a particularly broad-based run that we've had in the market and what we're seeing is we have concentration at all-time highs in the S&P 500. We've got five big mega-sized technology companies that are... They're approaching 25% of the value of that. So you think, "Oh, it's 500 companies," but it's not an equal weight of 500 companies, that index weight's comprised as price weighted. So as we're thinking about diversification, just in general, I have a concern that a lot of folks say, "Well, I am diverse, I have the S&P 500 in my 401K," or, "I have a mutual fund that owns a lot of stocks." But we wanna be careful as we look through that, consult your professional, get your own advice, run the analytics and figure out what is my exposure to this very small basket of high-performing stocks that have done very well, it's great that you've got those returns, but I really think it's time now to get some expert advice, or do your own deep dive homework and see what is the risk? What's the flip side? Investing to know what's in the future, it might not be this thing for those companies as it has been the last few years.

0:09:02.2 Mark: Alright, Scott, I want you to repeat the Talmud's saying once more 'cause that's my takeaway today.

0:09:09.7 SO: So as I've seen it quoted, it says, "Let every man divide his money into three parts, invest one third in land, one third in business and one third in... Keep one third in reserve."

0:09:20.7 Mark: We are talking with Scott Oeth. Anything else you wanna add this morning, Scott? That was great.

0:09:25.6 SO: Yeah, no, I really enjoyed the conversation, Mark, and, you know, folks have any questions, feel free to send me an email, follow along in my blog, I try and keep things updated there, current and also timeless topics.

0:09:37.8 Mark: Alright, Scott Oeth. We'll be talking finances with Scott on the first Wednesday of the month on North Shore Morning. Thank you so much, Scott.

0:09:44.3 SO: Thanks, Mark.