Happy Day to you. This is Ken Kaufman CFO. And I am thrilled you’re here for episode number 25, cultivate with diversification. Now, this is all part of the series that I’m doing on the roadmap to cultivating your assets, which is all part of the impact your net worth model. Let me start and introduce diversification with this example. My wife and I are concerned that when we get old, that we may need somebody to take care of us. And so, a potential plan for that would be that we look to one of our children to be able to take care of us. And so, we could have chosen to have one child. But what if that one child decided they didn’t like us, or they didn’t want to take care of us when we were old and had needs and needed help? So rather than have one child, we had eight. And what happened is, that increase the likelihood that at least one of those children would step up and help us out if that need should ever arise.
Now, I’m not saying having one child is bad, or that having eight children is good, or anywhere in between, or more or less. That’s up to you and what’s best for you and your family situation. I merely use it as an example. Having just one child in that example concentrates all of my potential outcome into one person. Spreading that out over eight, it increases the likelihood, or in essence, decreases the risk that there will be nobody there to take care of us when we’re old and have that need. Another example of being too concentrated in terms of your net worth and your income that I see very common, and it’s not a bad thing. It’s actually a great thing if you can build in the discipline to start to diversify. But it’s for people who start a business. If you have started a business and you’re building and growing a business, congratulation. Hats off to you. Nobody is a bigger fan, and a bigger cheerleader for entrepreneurship. In fact, that was one of the points of emphasis in my MBA degree at the University of Georgia back a couple of decades ago.
So, you own this business. The challenge here is, is that most likely over time, you’ve got quite a bit of net worth wrapped up in this business, as well as it’s likely the primary, or maybe even your only source of income. Nothing initially bad with that. But what happens if something happens to your business? And for some reason, its performance declines, or the industry that you’re in starts to see economic challenges or struggles. I won’t make up all the potential things that could go wrong, because there’s certainly a lot of things that could go right as well and you could have one big winner. But the takeaway point here is, is that diversification is about risk management. It’s about risk mitigation. It’s about saying, “Here’s the outcome that I’m trying to create. And is there a way that I can do that while being exposed to the least amount of risk possible?”
So in the last episode, we talked about asset allocation, meaning between stocks, and bonds, and cash. And there are other asset classes too, you could throw real estate in there, and commodities, and futures, and all of those different things, and currencies, and crypto. You have all of those different asset classes. We started, I’m sorry, last episode with those main three, stocks, bonds, and cash. Well, what happens if you have $1,000 to invest and you’ve decided, “I wanna do a 70% stock, 30% bond, 0% cash portfolio”?And you say that’s $700 or 70%, “I’m gonna invest all of that into Amazon stock. And the 30%, I’m gonna invest all of that into a bond. And then I’m gonna have nothing in cash, in CDs or money markets or savings accounts.”
So you’ve begun to diversify where you have stocks and bonds, but you only have one of each. What if you could own 10 stocks or 100 stocks? Or what if you could own, you know, multiple different bonds with different risk categories, or I should say with different ratings in terms of very likely that you’ll get repaid versus not very likely. And so you have different interest rates, and they’re different terms, in terms of maybe it’s a 90-day bond, and then there’s a 5-year bond, a 30-year bond. And there’s a way to diversify amongst all of those different types of bonds. Picking one and saying, “This is now my exposure to stocks,” most likely, we’re missing out on an opportunity to reduce the risk that that one stock could be a loser. Reduce that risk and get ourselves to a place where we could get a better return.
Now, if you pick the one winner, you would definitely outperform somebody who’s diversified. But let me tell you what the problem is with that. And actually, this academic research is quoted in an article that Paul Merriman did recently for MarketWatch. And it’s called, “10 Things You Should Know About Diversification.” He cited a study that’s actually commonly cited in the financial industry, that all of these studies from the academic show that in the financial markets, only 4% of the available stocks to purchase are responsible for creating all of the gains over time. And so, what that means is, 1 out of every 25 stocks that you could pick is the one that creates the gains, and actually covers up for the mediocre performers, the no performers, and the negative performers.
So here’s the challenge. How do you pick the 1 out of 25? The experts can’t even do it. Most of the time, there are studies that show that the experts over time, the top money managers, if you will, over time, fewer, and fewer, and fewer percent stay in that top performing category because everything, as John Bogle talks about in his book, “The Little Book of Common Sense on Investing,” he talks about how…there is a reversion to the main, to the average across the whole market. So picking the one or hiring people to pick the one that’s going to beat the overall market is very tricky. And you expose yourself to a lot of risk if you just pick 1, or 2, or 10. But when you start to pick 100, or 500, or 1000, there are some mutual funds or ETFs that can actually cover 9,000 to 10,000 different companies where you could have ownership by just buying that one mutual fund or that one ETF. That is called diversification.
Oh, and by the way, I’ll put a link to that article in the show notes. So make sure to go there and check that out if you’re interested in the article and what the academics say. So you have stocks, bonds, and cash. And then in each one of those, you wanna start to diversify yourself out, and not just on one stock. Well, now, you also, if you’re gonna buy 10 different stocks, you probably don’t necessarily want to buy them all so that they’re exactly the same. And the way that the financial markets break this out is basically stocks fall into one of three sizes, and then one of two types that makes for a really nice grid, and I’ll put a link in as well, called the equity style box. And in essence, what it does, each stock is broken up by size into one of three categories. If it’s over $10 billion in market capitalization, that is a large company or a large capitalized stock. They’re called large cap. If it’s between 10 and 2 billion in market cap, then that is a midcap stock. And if it is 2 billion or less in market capitalization, then it is known as a small cap stock.
And then within each of those three buckets, there are stocks within those that are either value-oriented, or growth-oriented. A value-oriented is stock that’s usually a lower price relative to its book value, its earnings. Growth stocks have higher, what’s called, price to earnings ratios. And there’s more hype around the fact that this could be a real growth company. And generally speaking, if you’ve heard of the company in the news, or it’s just common out there that people talk about, it’s likely a growth stock. Value stocks are often ones that you don’t know, unless you’re in that industry, or you’re very familiar with somebody that works at that company, or had some exposure through vendor customer relationships, and those sorts of things.
So within this style box, or within this equity style box, when I say I wanna own 10 stocks, or 100 stocks, or 1000 stocks, it actually can make a lot of sense to really consider spreading yourself out amongst these asset classes or these sub asset classes rather than owning just one asset class. You could buy 100 stocks, and they’re all large cap growth. But what about large cap value? And what about small cap and midcap? So very important to understand when we diversify, that we consider all of these sub asset classes, and that includes these stock funds that can invest in real estate investment trusts, and other assets beyond just regular companies.
Now, in addition, you can now consider regions or geographies. A lot of times when we talk about the stock market, the S&P 500, or Dow Jones, or the Nasdaq, these are U.S.-based companies. There are lots of amazing companies with lots of growth potential and value that are domiciled and headquartered overseas. Some of them are in developed countries, some of them in emerging markets. And so, not only can you focus on diversifying between large, medium, and small, and value, and growth, you can also diversify between international developed, international emerging markets, as well as U.S. companies. And that goes the same with bonds with government or municipal issuers, as well as corporate entities in all of these various countries.
So when we talk about diversification, there’s a lot to it. And you can definitely over diversify, or you can also be way over concentrated in one area. The over diversification, it just means that now, you’re just buying things and it’s not really mitigating risk anymore. The opposite of that is you get too much concentrated and you’re exposing yourself to much more risk. There is potential for return, but at some point, taking that extra risk just isn’t worth it. So when we break all this down, the key takeaways are this. Number one, diversification is a methodology, is a process for risk mitigation to make sure that the return that you desire and that you’re trying to achieve, that you are exposing yourself to as little risk as possible relative to that return or to that potential outcome. The second key thing to understand is that there’s lots of ways to diversify. And the most effective, and efficient, and cost-effective ways to diversify are to buy usually mutual funds or ETFs that represent specific types of companies in different equity style boxes, as well as within different geographies, U.S., international developed, or emerging market.
And what your personal strategy is depends a lot on how old you are, how much risk you feel like you can tolerate without. Because if you expose yourself to too much risk, then you start to do emotional things like sell when the market goes down and buy when the market goes high. I know that on paper, and just me saying that, that sounds silly that anybody would ever do that. But there are times when we just can’t stomach the risk and we get so nervous that we sell out. I’ve known many people who do that. In fact, I know of somebody that did it back in December when the market went down, they sold out and they said, “I’m out of this market. I can’t handle the ups and downs.” And then the market went right back up. And they’re still sitting on the sideline waiting to get in, and the markets just been going up since then.
So, this is what we’re talking about when it comes to risk, getting the proper diversification. So you own a lot of different companies across a lot of different asset classes and sub asset classes, bonds, and money markets, and all of those things. All of that brings us to this power to cultivate your assets with the help of properly diversifying those assets amongst all of your asset classes and sub asset classes. So, we’re gonna continue to talk on this subject of cultivating your assets. I encourage you to subscribe to the podcast. Also feel free to leave a review. I’d love your feedback about the content and if you find it helpful. Many, many thanks to you for joining today. This is a wrap for Episode 25, Happy Day.
Links Referenced:
10 Things You Should Know About Diversification
Diversification with Different Equity Asset Classes – The Equity Style Box
