Think You’re Diversifying Investments? Not Really.

Jim Lorenzen, CFP®, AIF®

Investment diversification, reducing investment risk, may be one of the most misunderstood of investment principles.  I’ve seen tv stock gurus tell you that owning three stocks in different industries passes for investment diversification, implying that risk is being reduced.  I don’t think so; it’s just compounding investment concentration.

Believe it or not, you can’t possibly diversify-away market risk.  Think about it; you could own every single stock contained in the S&P 500 Index and all you would have done is duplicate the market’s risk.

I’ve also seen investors buy multiple mutual funds in an attempt to diversify; but, since everything they bought had to be “quality”, all they did was duplicate their holdings (portfolio A) instead of diversifying them (portfolio B) across multiple investment styles (growth/value, large/small, etc.).

Diversification, done properly, can smooth things out, as this simple example shows.

But, what stocks?  Which bonds?  Is buying a few enough?   The answer, of course, is “it depends”; but, it’s worth noting that there are five basic asset classes (stocks, bonds, real estate, commodities, and cash) and within each there are multiple sectors.  It’s also virtually impossible to know which will outperform all others in any given year.  Yet, diversification among them can smooth the ride!

I’ve been telling clients for more than two decades now, “We’re not diversifying money.  We’re diversifying risk; we just do it with money.”

So, how do we diversify risk?  It’s all about something called correlation.

You can think of correlation as pistons in an engine:  They all go up and down, but not necessarily at the same time.  Their going up and down is what propels the machine, but you wouldn’t want your money on any one piston.  If the engine were to stop, you’d have a 50/50 chance of being up or down!  But, if your money was spread over all the cylinders, you’d still have a stable overall value regardless of when the engine shut down.

It doesn’t really work all that clearly in the real world of investing, of course; but the theory is no less valid.  Here’s a chart the relative correlations among a number of classes and styles.

 

 

 

 

 

Correlations don’t remain the same, even from day-to-day; so, they’re not in stone – they just give us a historical look at their relative movements, but the numbers will be different depending on the time-frames chosen.

Diversification is all about correlation reduction in portfolios.  I created a report on all this a while back called Understanding the Diversification Puzzle.   You might find it helpful and you can get it here.

Enjoy!

Jim


Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® serving private clients since 1991.   Jim is Founding Principal of The Independent Financial Group, a  registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

SBA Small Business Week Begins April 30th

Jim Lorenzen, CFP®, AIF®

Small business webinars will be available the week of April 30th to help celebrate Small Business Week.

SBA Secretary Linda McMahon announced this on the SBA website:

The countdown to National Small Business Week (NSBW) is on!   NSBW (April 30th – May 6th) is an annual event hosted by the U.S. Small Business Administration to recognize the nation’s top small businesses, entrepreneurs, small business advocates and champions, and will feature a series of small business webinars.

These small business webinars cover a wide variety of topics:

The U.S. Economic Outlook and Its Impact on Small Businesses

Presented by Visa
May 2, 2017 | 2:00-3:00 pm ET
Register here

5 Fabulous Habits of Local Business Champions

Presented by YP
May 3, 2017 | 2:00-3:00 pm ET
Register here

Grow Your Business Online
Presented by Google
May 3, 2017
4:00-5:00 pm ET

Register here

The Future of Small Business Innovation
Presented by Salesforce
May 4, 2017
2:30-3:30 pm ET

Register here

How to Write Your Email Content in 15 Minutes or Less

Presented by Constant Contact
May 4, 2017 | 3:30-4:30 pm ET
Register here

Find the Hidden Money in America

Presented by Chase
May 4, 2017 | 5:00-6:00 pm ET
Register here

 

IFG has also created a report, “How to Establish Business Value” – information that can be useful for evaluating the impact of major purchases on business value going forward.  You can get it here.

Enjoy!

Jim


Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® serving private clients since 1991.   Jim is Founding Principal of The Independent Financial Group, a  registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Inflation, Stocks, and Computing Investment Returns

Jim Lorenzen, CFP®, AIF®

People are often either surprised to hear that stocks are probably the best inflation hedge they’ll ever find – or they really don’t understand why.

Those who intuitively believe it believe it’s simply because stock prices tend to rise over time; but, so do prices for other things, generally, including real estate.  After all, as a long-term hedge, most real estate is a good inflation hedge, as well.  It’s only real drawback, most believe, is the lack of liquidity it entails.

When my parents retired, the common practice was to simply “ladder” bond or CD maturities as many counted on rising interest rates to offset inflation.   While inflation had averaged only 2% in te 1950s and 2.3% in the 1960s, all of a sudden climbed to 6.2% in 1973 and by 1974 had reaced 11%.  Bonds, of course, paid higher rates to the holders, but after taxes, the income didn’t keep up with inflation.

From 1973 to 1982, inflation averaged 8.7%!  A little math reveals that the purchasing power of bond income had declined 57% in just one decade; and, as many found out, they were living longer, too!

Enter the 1980s and a newfound interest in stocks, which continued into the 1990s and even into the 2000s.  But why?

The reason lies in a simple, basic premise:   stocks represent shares of ownership in businesses – businesses that sell goods and services in the marketplace.  When you eat breakfast, everything you eat or drink was grown, packaged, distributed, and sold by a business.  Everything we consume was sold by a business.  The largest providers, distributors, and sellers are publicly held – the ownership shares are owned by people like you and me – and often in their 401(k) plans through their ownership of mutual fund shares, which are shares of ownership in investment companies which, in turn, buy shares in publicly held companies.

So, if prices go up, stocks go up.  Is it that simple?   Actually, there’s more to it.

iStock Images

Take an (admittedly oversimplified) example of a company that generates $1 million in sales and $800,000 in expenses.  Let’s assume the remaining $200,000 is paid out in dividends.

If inflation causes prices to double, sales rise to $2 million and expenses rise to $1.6 million, now creating $400,000 in dividends.  Dividends have doubled, despite the fact that all margins have remained the same.  That’s how stocks become an inflation hedge, with liquidity.

This is exactly what happened throughout the 1980s.  The decade began with the S&P paying out around $7 in dividends, when the index paid out a 5.3% yield as it stood at $133.  By 1990 it was paying out around $12.50 when the index was up to $340, for a 3.7% yield.   As the yield went down, stock prices went up; yet, the investor saw cash flows rise from $7 to $12.50!   This actually did better than inflation, which averaged 4.7% – up 58%.

Of course, dividends are not guaranteed and stocks have both business and market risk – a good reason why people relied on “blue-chip” stocks and a sound asset allocation process.

It’s also important to understand investment returns, including their measures (there’s more than one) and why most individual investors typically don’t do as well as institutional investors.  If you’d like to learn more about this topic, you might want to see our report, which you can access here.

Enjoy!

Jim


Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® serving private clients since 1991.   Jim is Founding Principal of The Independent Financial Group, a  registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

A Slick 2017 Market Outlook Infographic!

Jim Lorenzen, CFP®, AIF®

Jim Lorenzen, CFP®, AIF®

Here’s an interesting market outlook infographic from Vanguard!  Thought you might enjoy seeing it!

Just click on the image; you can enlarge it.

The White Paper referenced was written at the end of last year, but you may still find it interesting.  You can get it here.

Enjoy!

Jim


Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® serving private clients since 1991.   Jim is Founding Principal of The Independent Financial Group, a  registered investment advisor with clients located across the U.S.. He is also licensed for insurance as an independent agent under California license 0C00742. The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.