The big idea and why it matters: Diversification shouldn’t be confused with simply “spreading out investments.” A sound process for selecting an advisor, conducting financial planning, and constructing an appropriate portfolio (including Alts!) can help to avoid many diversification and investment pitfalls.
“Wide diversification is only required when investors do not understand what they are doing.” -Warren Buffett
Continuing with our process
As we covered in Part 1, investors (and humans, in general) should focus on processes to drive successful outcomes over time rather than concentrating on the outcomes themselves. To Mr. Buffett’s point, simply spreading out investments may have less utility than people believe, and I often see approaches that are mistaken for sound diversification processes. Today, we’ll look at some common pitfalls and round out this conversation with a touch of Alts. Here we go!
Putting “eggs in different baskets” is often not a sound process.
You’ve likely heard the phrase, “Don’t put all of your eggs in one basket.” The concept is good in the spirit of diversification or risk management, but the interpretation/execution often lacks both. If I (literally) spread my dozen eggs across twelve different baskets instead of keeping them all in one basket, it won’t help if all those baskets sit in the same pool of hot lava. All of my eggs will still be incinerated. The problem is the lava – not the basket.
Yes, I realize that’s a ridiculous example, but you get the point: the baskets need to offer different characteristics from one another if the goal is to preserve most of my eggs most of the time. Otherwise, I’m not diversifying the risk. Similar logic applies to diversifying investments, and there are pitfalls to watch out for:
- Pitfall 1: choosing investments that seem different but aren’t.
- Pitfall 2: spreading money across multiple institutions.
- Pitfall 3: spreading money across numerous financial advisors.
Pitfall 1: choosing many investments that seem different but aren’t. I recently reviewed an account of legacy investments for a client consisting of various ETFs, mutual funds, and a stock. The ETFs and funds were from a few different providers, and the funds’ names varied enough to sound like they invested across a diversified spectrum of holdings (e.g., Blue-chip Growth, Large-Cap Index, Infrastructure Technology, the NASDAQ Index). The problem? All of them had essentially the same top holdings. And one of those holdings was the individual stock the client held. Eggs in one basket? Yep.
One thing that could have been a clue was that all those funds had performed very well in 2023 and thus far in 2024, moving in tandem with the market, other technology stocks, and one another. If investments are moving closely together, it should at least lead us to question the level of diversification involved. Sometimes, genuinely different investments will move together (i.e., appear correlated), but the reason for those movements may vary. It’s enjoyable when everything moves positively, but it can be a portfolio killer during inevitable downturns.
Pitfall 2: spreading money across multiple institutions for no defensible reason. As with the first example, you can spread your money across Fidelity, Charles Schwab, Pershing, and all the banks you can think of. Still, if you’re investing in the same thing at each, then it won’t diversify your portfolio. Additionally, you’ll get tax forms from every institution, which can add complexity, annoyance, and cost to tax prep (I view that as a bad thing, but to each his own).
I have seen valid reasons to utilize multiple institutions, but it’s usually limited to banking and lending relationships, particularly for business owners.
Pitfall 3: spreading money across multiple advisors. This phenomenon is one we run into pretty often, and there are several things to watch out for:
- The same phantom-diversification trap as above applies. You can have the same investments with each advisor – particularly if those advisors have no idea what the other one is doing.
- You’ll likely pay more in fees since you don’t get the scale/benefit of your total wealth, which drives down pricing with one advisor (typically a percentage of assets they manage).
- Financial planning is far more challenging to coordinate and implement across multiple advisors. And if the planner cannot directly implement the advice, it’s left to the client, so it’s far less likely to get done (this is why it is most challenging to get clients to implement estate plans – we cannot do it for them!). One advisor must be the lead to manage the overall situation comprehensively. That means the other advisor must be relegated to being a money manager, so why not just invest directly with a manager? If both are doing full financial planning, it seems like a lot of wasted time and resources for everyone involved.
As David Bahnsen has written, trust is essential to an advisory relationship, and trying to maintain multiple advisory relationships often means the client doesn’t entirely trust either of the advisors or their respective strategies. Building trust can take a lot of time, but it’s best to be upfront about intentions because a trusting relationship cannot be built on deception.
With open communication and truly different strategies, the diversification aspect could work. Still, there will be downsides of higher fees, more time involved, and less streamlined results/outcomes to consider until the single best-fit relationship is determined.
Where do Alts fit into all of this?
The whole point of utilizing alternative investments is introducing different sources of income, risk, and return into a portfolio. With today’s theme in mind, it’s vital to have a solid process for selecting Alts strategies/managers we use, but high-quality Alts have the potential to provide diversifying characteristics that are unattainable in traditional public market investments.
An investor can own all of the stocks and bonds they’d like (and mutual funds and ETFs full of stocks and bonds) and spread them across ten different advisors at ten institutions; still, it will amount to a less diversified portfolio than a properly constructed portfolio of stocks, bonds, and alternatives held with a single advisor.
It all comes back to the process. A sound process for selecting an advisor, conducting financial planning, and constructing an appropriate portfolio (including Alts!) can help to avoid many diversification and investment pitfalls.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
