This week’s guest is Brad Clark, Clarify Wealth’s Chief Investment Officer. He has been in the financial industry since 1987 and managing investments since 1995. He joins us today to share his thoughts on the importance of diversification in your investments.
Hi Brad, thank you for taking the time to join us. Diversification is something probably every investor has heard of, but a topic that has a lot of different definitions depending on who you ask. To get us started, how do you define diversification?
Well, it comes down to having a portfolio that has a broad mix of investments that don’t all behave the same. We want to invest in a way that provides long term growth potential while trying to mitigate risk whenever possible. In a prudently diversified portfolio we expect to have investments that don’t all move in the same direction at the same time. For example, owning a dozen different mutual funds you might think you are diversified. However, if these mutual funds own similar holdings (i.e. large cap US stocks) they will be highly correlated, meaning they are going to move up and down at the same time. Good when they’re all going up, not so good when they’re all going down. In contrast, a prudently diversified portfolio often has some investments that are up while others might be down.
So when it comes to creating a diversified portfolio, what types of investments could an investor consider?
There are a lot of options, probably too much to get into here, but our basic building blocks include stocks (large and small, both domestic and foreign), bonds (government and corporate, both domestic and foreign) and cash. Depending on our economic or market outlook we may also include alternative investments such as real estate, commodities or inflation protected bonds. We favor exchanged traded funds (ETFs) for their generally lower fees (compared to many mutual funds) and tax efficiency. However, we will also use actively managed mutual funds if we feel they can add value (enhance returns or reduce risk) compared to their benchmark.
Is there a particular mistake you see average investors make in regards to diversification within their own portfolios?
I think it’s tempting for many investors to choose their investments based on returns alone, and sometimes making the choice based on very recent returns. Often this approach leads to a portfolio full of identical investments that have all been performing well based on current economic or market conditions. Of course, conditions always change and what works today may not work tomorrow. Unfortunately it’s extremely difficult to predict changes in advance. So what tends to happen is investors buy what’s already gone up (buying high), sell when the investments go down (selling low), and then turn around and buy what’s already gone up (buying high), and so it goes.
So you do a lot of the portfolio construction for investors at Clarify to help avoid pitfalls like what you mentioned above. How do you create a portfolio that can mitigate some of those risks, but still capture returns?
First, we want to know the investment goal. Is it for retirement, college, a new boat next year, etc.? In other words, when will the money be needed, what is the investment time frame? This allows us to match our investments to when the money is going to be needed. In general, the shorter the investment timeframe the more conservative the portfolio should be. For example, if an investor is going to be drawing on the investments within a couple years we might only have a very modest allocation or no allocation to stock. Stocks might be down and not have time to recover just as funds are needed. On the other hand, with a long investment time frame, we might weight the portfolio heavily in stocks for better long term growth potential.
Along with knowing the investment time frame, we want to determine the client’s risk tolerance. The goal is to get an understanding of how comfortable the investor is with the ups and downs of the market. For example, are they someone who can handle seeing their portfolio drop in value during a bear market and wait for it to rebound, or are they someone who would probably panic sell during a downturn and lock in losses. The goal is to understand where a client falls on the risk spectrum and use that knowledge to help build a sustainable portfolio.
You mentioned a sustainable portfolio, what is that?
A sustainable portfolio has two components. It has the growth potential to realistically achieve the investment objective (retirement, college funding, etc.) and it has enough stability to allow an investor to hold the course even during the bad times. A sustainable portfolio builds on our belief that you can win by not losing. For example, if you invest a $1,000 and lose 50%, you’re down to $500. If you gain 50% the next year you’re only back to $750. You’d need a 100% gain to get back to breakeven.
As there’s no way to know when the next financial crisis will hit, what do investment managers like yourself focus on when an investor decides to ask for your help with managing their savings?
We try to focus on the things we can control. We’ve talked a lot about properly diversifying your portfolio, which is huge. Through proper diversification we can, to a great extent, manage risk. We also focus on tax management and cost, both of which we have a great degree of control over. We can’t control how markets perform so we don’t spend a lot of time trying to predict what’s going to happen in the short term. We do closely follow the economy and markets and have our long term views which are reflected in our portfolio allocations. We just don’t spend a lot of energy trying to predict the unpredictable.
I say this as a hypothetical question, but I’ve actually been asked this a lot, and see it on website forums frequently as well. In your opinion, if you’re a younger investor, is it ok to be 100% stock?
I’ve been asked this a lot as well. If your investment timeframe is multiple decades, then there’s nothing wrong with a 100% stock allocation. The odds are you’ll have plenty of time to recover from the inevitable downturns. But there is a critical caveat to this that does not make it the right approach for EVERY younger investor. The caveat is that you won’t panic sell when the downturns occur. Selling when investments are significantly down could mean the investor is worried the markets are not going to recover anytime soon and they’re better walking away. This could result in not reinvesting until long after the market rebounds and becomes stable again. The end result here is someone who bought in, sold at a loss, and bought back in again once everything already went back up. For an investor who isn’t comfortable with significant volatility, even if they have a long timeframe, a 100% stock portfolio may not be the most appropriate.
Well, thanks for your time in doing this. In addition to the importance of diversification, I know you have another passionate… some might stay stubborn… opinion that the best movies were made in black and white. Could you name 10 movies made in the past decade off the top of your head?
Probably not. But I can name a hundred made before 1950.
This information is not intended to be a substitute for individualized legal advice. Please consult your legal advisor regarding your specific situation. Clarify Wealth Management and LPL Financial do not provide legal advice or services. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.