I stepped away from the keyboard this week and invited Hixon Zuercher Capital Management’s Research Analyst Austin Wilson, to share his take on the most crucial ingredient of investing… diversification!
First of all, I would like to thank Jess for asking me to be a part of this amazing blog. She provides truly inspiring words for many.
I spend a lot of time reading financial blogs and news. I listen to podcasts and watch Bloomberg and CNBC constantly. I am inundated with what is going on… which is a lot… and much can be distracting from the end goal. Generally, that goal is to have enough money saved and invested to be able to meet your needs for your lifetime (and beyond).
But all the nitty gritty stories and news topics rarely take the time to break down the fact that building wealth is actually pretty simple. Sure, it takes effort, discipline, and sacrifice, but it’s not overly complicated.
One of the pillars of successful wealth building is diversification. And I’ll preface this section by stating that I will be focusing on diversification as it relates to the equities (or stocks) in your portfolio. I believe stocks are the best way to build wealth, but I’ll leave that for a future blog (sorry, Jess).
Diversification in its most basic definition is not having all your eggs in one basket. The old adage is true. If you are investing for the long term (as opposed to day trading), it is important to build a portfolio that will do well in a variety of economic situations.
In my opinion, this breaks down into a handful of categories to have exposure to, and then each of those have subcategories:
1. As a proud American citizen, I may have some bias towards my homeland; but I believe that every portfolio should have a healthy dose of traditional, large-cap U.S. stocks. These will be the drivers of the portfolio that will provide healthy growth as our great nation is the world leader in innovation… a trend we are all working to continue. Large-cap U.S. stocks typically have less volatility than stocks from companies based elsewhere, which can help investors sleep at night. It is also a huge help that our financial system is highly regulated and transparent.
2. After that, it’s a good idea to have exposure to developed international stocks. These economies (think Europe and Japan) grow at different rates and have different things going for and against them at any given time. Another wildcard for these markets is the impact of currency movements. Stocks in this part of the market do not move in lockstep with U.S. stocks, and that is a good thing. Plus, I think we often forget that there are growing and innovative companies all around the world.
3. A third pillar to a diversified equity portfolio is exposure to emerging markets stocks. These are some of the fastest growing economies in the world and include countries from Asia, Africa, and Latin America (we often refer to emerging markets as the BRIC countries, as they include Brazil, Russia, India, and China). Regulation inconsistencies and currency movements can be dramatic in these markets, so this type of investing is often significantly more volatile than investments in more developed regions. However, the growth in these areas can be found nowhere else. The regulatory environment is also improving each year around the world.
4. Small-cap U.S. stocks are another area to have some of your nest egg invested. This area of the market is very closely tied to the economic cycles that we see. They perform very well during expansions and lag a bit during contractions, but over longer time frames, investors have been rewarded with better returns. This is because the investments that have been more volatile over time have often rewarded investors with higher returns (because why else would someone hold something with large price swings?).
As I mentioned, within each of those 4 broad categories are multiple subcategories, each of which can typically be accessed through investment in an ETF, mutual fund, or individual stock:
1. You can invest in “Blend” investments. These are typical, established, growing-at-a-sustainable-rate companies. These companies are usually a representation of the market as a whole and may be accessed via an index fund or ETF.
2. Alternatively, you can invest in “Growth” companies. These are often the highest… you guessed it… growing companies that are innovating and changing rapidly. These generally do not pay dividends as they are constantly reinvesting in the business and usually trade at a substantial valuation premium to the overall market.
3. Next up are “Value” companies. These are your old-school, slow-growth, steady-as-she-goes companies that have been around for decades. They have fortress balance sheets and usually pay a sizeable cash dividend. The companies may offer value because they are underpriced in the market and their stock prices could increase more towards their average.
4. Real Estate Investment Trusts (REITs) are another area of the market to invest. Due to the way these corporations are treated, they must pay out 90% of their income as dividends to shareholders. There are REITs with exposure to many different areas of the market from large to small, from technology to malls.
A portfolio’s weightings in each of these categories and subcategories will be different for everyone, depending on their goals, time horizon, and risk tolerance.
Please know that these investment categories will not always go up and down at the same time, or by the same magnitude. My colleague and co-host of The Invested Dads Podcast, Josh Robb, would say if everything in your portfolio goes up at the same time, you probably aren’t diversified. It’s great when that happens, but when the market enters a deep correction or, heaven forbid, another bear market, everything will also go down at the same time… no bueno.
So, the next step is how do I diversify my portfolio? There are 2 ways:
- You can easily accomplish this with mutual funds or ETFs. You can buy securities in each of these categories that are either actively or passively managed. You could buy securities that do it all and blend the categories together or split them apart. At the end of the day, what is most important, is just that you are diversified. Once that occurs, you can fine tune how are you are diversified.
- You could also work with an advisor who knows what to do. It is their job to put together portfolios to help you meet your financial goals over time and make adjustments as life happens to keep you on track. These people are pros and worth every penny that you may pay them in fees (though I may be biased being in the business). But for real, having someone like Jess in your life who knows her stuff may be the best investment you can make.
When you have money, buy. Buy when the market is up. Buy when the market is down. Don’t sell unless you need money. Stay diversified and don’t look at your accounts too frequently, and you will succeed with your investments. And please don’t forget to rebalance regularly.
Pro-tip: use your regular investment contributions to add to your most underweight areas to keep allocations in check!
Again, thanks to Jess for asking for my thoughts this week. I am always happy to share!
Until next time, friends,