What Diversification Actually Means

Welcome once again it is Mr. Stillman's opus John Stillman here alongside Bob paying the joints today.

Bob is the chief investment officer at Payne capital management in New York City.

Bob, thanks for being a John it's it's always good on the radio with alleged so I appreciate the opportunity to speak to your audience today. I'm sorry that we could notify the legends join you today but maybe next week are sounds good to me well to talk with you about was the idea of diversification. Everybody I think universally agreed on the importance of having a diversified portfolio, but I don't know that people really understand what a diversified portfolio truly is. So let's talk about what diversification is and what it's not.

First of all, maybe gives an example of someone who believes they have a diversified portfolio, but in reality they don't where I think I can understand confusion because every buddy in the financial service industry talks a good game about diversification doesn't necessarily understand themselves on top of that you might have some financial contents. For example, there's a show on CNBC where there's a segment on are you diversified and if you have five stocks. That's it.

You have five stocks from five different industry sectors you're deemed to be diversified. Now that is financial pornography at its height, and is the worst bit of advice I think I've ever seen, so I can understand when people are told that there diversified that they think they may be, but the facts belie the truth. It's hard to believe this might say, well, I have five different stocks on the verse five he said it's in different sectors. But the point is there still all stocks in basically American companies right all American companies in one sector of the of the market so that basically he's looking at the 10 or 11 sectors of the S&P 500 is picking five large company stocks now. Believe it or not John there were more than 500 stocks publicly traded about that.

What would you guess would be the amount of publicly traded companies globally today globally. While I have no idea closing in on 12,000 so were the chances that you're going to have next year's winner in the market, only five stocks versus owning 10,000 stocks and if there are 12,000 stocks and how many different bonds are there because the bond market is even substantially bigger than the stock market right substantially bigger but it is not as differentiated, you know, for example, you have your municipal bonds treasury bonds junk bonds international bonds they're all they'll trade basically on on maturity, credit quality and where interest rates are so you don't have to be as diversified as in a bond portfolio as you don't start portfolio because there deftly will be called negatively correlated not hate to throw Wall Street gibberish out to two folks today, but basically what negative correlated means you want to have a portfolio of investments where they act differently at different times, so sometimes you can have bonds going up all stocks are going down and you'll have stocks going up why bonds are going down, but within the stock market. For example, last year you had US stocks were making marginal movements to the upside, while international stocks are going down this year. You have the opposite of emerging market stocks are the best performing stocks in the world and outpacing US stocks by almost 300% when you're building portfolios for your clients.

What are some of the more alternative type investments that you include in their outside of just know the traditional stock and bond world. Well is this talk about true diversification to begin with true diversification. I think of it as a four legs of a stool, you have to have these four legs that a truly diversified portfolio and then got to be diversified within those leg so to speak. So you need to have a portfolio of bonds and basically you should only buy high quality bonds that have a fixed interest rate fixed coupon six maturity date, you should have a diversified portfolio of stocks, both US and international stocks you should have a portion of your portfolio in income generating real estate which is not there, publicly traded stocks but they act differently than the US and non-US stocks and you want to have a portion of your portfolio in hard assets or alternative investments like commodities, so there is a four legs of the stool that every portfolio should have not should be the initial acid test of whether or not you are truly diversified now was in that you should have diversification across asset classes and within asset classes just to explain or mean there. Let's take let's take the US stock market US stock market, you have the S&P 500 and we all know that there must be 500 stocks in that index easy will then their small company stocks which over any 20 year period in history have typically outperformed large company stock, sometimes by 100%.

Now those small companies stocks are represented by an index called the Russell 2000 index so that he had midsize company stocks which again treated differently and typically over time. Give better performance in large company stocks and even in large company stocks in the S&P 500 half of the stocks we call growth stocks. The other half or value stocks.

So what does that mean will first of all gross stock would be something like a Facebook in over a Google something is growing rapidly doesn't pay a dividend is is growing much faster than your typical company that's a good growth company. It's a large company growth stock. So what's a value stock will value stock of something like Exxon or something like Merck or J.P. Morgan bank. These are old stodgy blue-chip companies not growing very rapidly that they're paying a nice dividend. They typically increase the dividend every year and they've got a giant moat around her business. So it's very hard for people to compete. They been in business a long time and most likely will stay in business for a long time now there's a great question John over your lifetime.

What's done better value companies are growth companies.

Well, I mean certainly a lot of the growth companies took a big hit big step backwards in the.com crash right through.

I would have to imagine that they've had some really big years, but some really down years. While value has crept up a little more hello I'm either probably pretty close to even write with think so, but it's hands down. Value outperforms growth over because I don't have the bigger hits in the down years. So that's exactly and and and they have dividends and dividends to get increased and compounding of interest and dividends is really the key to wealth creation. So when you look at a diversified portfolio. You can see why you want to make sure that your diversified across an asset class like stocks because over time.

Value outperforms growth small and midsize companies outperformed large companies, but they don't do it every year and I think the key to diversification is to have a smooth ride.

Miller was to keep the volatility down the dampen the change in price from week to week and month to month. That scares investors out of the market and doesn't allow them to participate in the phenomenal returns that the financial markets have produced for your generation by generation repair generation her grandparents generation. It's really about staying invested but making it easier to stay invested by having something working in your portfolio. When something is nowhere to have something going up while something else is going down, and even more importantly is taking his dividends and interest in having the courage and the intelligent strategy of buying loan other words, buying loan, a relative basis in your portfolio.

If your hundred percent in one investment diversified is that investor goes down your yield too much. So if you have small company stocks going down my large cup.

He starts going up, get an opportunity to create wealth by buying more shares, the way I've always heard you say it is. I don't know what's going to be up this year, but were going to own it. Well it's that's absolutely true job because in an and what I believe is a truly diversified portfolio. We only by low cost index funds. That way we get access to the market at the at the lowest cost, but we get to own. Basically every company out there. So not only do we own US stocks and small midsize needle growth and value. We also invest in international companies and emerging-market company places like China and India where you know China has 1.3 billion people. India has 1.2 billion people and you know as a businessman I think about 1.3 million potential customers were 1.2 billion potential customers is 320 million Americans. So you see the opportunity. I think in the future's gonna come from what we call emerging markets which do we know. I think we all know that those markets can be much larger than ours in the future so I will there still emerging to me they've emerged.

But if you've if you invest in across those asset classes within those asset classes and use index funds like we do, and you include alternative investments like real estate investment trust and midstream energy pipelines and commodities.

We basically own over 10,000 individual stocks.

When you break down a portfolio and that gives us a higher probability of only what's gonna be a big next year. Again, I don't know what is going to be. I just know but own it. Final thing for you, Bob, and this kinda goes back to what we talk about the very beginning with your people thinking they're diversified when they're not overlap in mutual funds. A lot of people say well I got 27 different mutual funds on diversified and in reality they actually don't own that many different companies within those funds. Now they don't.

I just jotted to set up a good client come in yesterday with a proposal from three major banks and these are all well known banks around the country.

Every single one of them had eight or nine or 10 different mutual funds in the portfolio, but when we put it through our x-ray we put it through our yard. MorningStar analysis. What we found was each bank was recommending 68% invested in large company growth stocks.

It didn't say that on the mutual fund wrapper. They all had different names so it say you can't go by the name of the fund is gotta dig a little deeper. He got up to get a unit strip off the veneer and take a peek behind the curtain to see what they truly own is very simple to do the just absent down the folk someone someone like you and have them do a portfolio x-ray and I'll tell them where the overlap occurs very interesting when people find out exactly what they owe.

Maybe every single one of their mutual funds buys Apple I seen that several times why that's exactly true I did.

I sat with the client the other day a new client of ours and we analyzed their portfolio that they own Apple six times as it's like by the same car six times over. We do drive one every day but make a lot of sense when you look out that way. But when it's in the mutual fund wrapper. You don't necessarily always know what you have, Bob, always good to talk with you. Thanks so much for making time. Absolutely no problem. John really enjoyed it.

Have a great day and then be bullish, absolutely.

That is, Bob Payne, chief investment officer a pain capital management's in New York City pain CM.com if you like to find them online. One of the money managers that we know and trust.

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