Do I Need a Diversified Portfolio? And Other Risk/Reward Questions

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“Wide diversification is only required when investors do not understand what they are doing.”

These are strong words from Warren Buffet, the CEO of Berkshire Hathaway, which arguably is its own diversified investment. Buffet has been known to say that concentration builds wealth and diversification protects wealth; that diversification is a hedge for when you are not knowledgeable.

That said, what should you do with your nest egg: build wealth or protect it?

The answer from financial planners is, do both. But to understand concentrated and diversified investments, we should discuss what asset allocation is, and why your financial planner cares about it on your behalf.

Buffet is right, of course, that concentration in the correct asset will produce wealth. But let’s also acknowledge that Buffet has always also held a huge stockpile of cash as a hedge against being wrong in his choice of asset. We mere mortals might also want to hedge our bets. And that’s exactly why we diversify our investments by not putting all our eggs in one basket. My goal would be for you to understand just enough to satisfy your curiosity. If you were truly motivated to learn about portfolio design, I expect you would have already. But you don’t actually need to immerse yourself in all things investments to be successful. There are just a few key concepts. This is one.

Before I get into stocks and bonds, let’s talk about diversifying your short-term savings. You may not even realize that you already do this. But if you keep your cashflow in your checking account, your emergency fund in a high-yield savings account, and the money you’ll need in say, seven months, in a six-month certificate of deposit (CD), you are diversifying. In this case, you’re diversifying between liquid and illiquid, interest-bearing and “barely” interest-bearing tools.

If some of your money is in the stock market, you are diversifying between assets with market exposure and assets that do not have market exposure. Hopefully we can agree that there would be risk to concentrating all assets in the market (market risk = the risk that the market will be down when you need your money) or all assets out of the market (inflation risk = the risk that your money will not earn enough growth to keep pace with inflation).

Now, the first thing you should know is that diversification reduces risk. And because it reduces risk, it also reduces reward. When I selected portfolios for clients, I tried to match the risk/reward tradeoff required according to the purpose of the money, the time horizon of the money and the client’s tolerance for volatility.

The first way to do that is to divide a portfolio into “market” and “non-market” (per above). Money you will need in the next two years does not belong in the market. (For more on this, check out Saving for a Fabulous 4th Quarter Harvest.) Next, we divide the portfolio into equity (ownership) and income (debt). Because stocks (representing equity) and bonds (representing debt) behave differently, we can mitigate a certain amount of portfolio volatility (think heart attack vs. healthy EKG) by choosing an allocation of stocks versus bonds.

Here’s how it might normally be arranged. These are approximate ranges, so give and take a few points in each direction. You’ve probably seen this on your 401(k) statement:

Portfolios may be further diversified to give you exposure to entire baskets of investments. These are mutual funds, exchange-traded funds, and index funds. (I’m not going to describe the differences in detail here. What you need to understand is that each represents multiple investments rather than a single investment.)

Are we good so far? Stay with me.

Now, all stocks (ownership) and bonds (debt) or stock funds or bond funds (baskets) are divided into groups by geography, company market capitalization, and duration (for bonds.) These are called asset classes, and there are nine to twelve democratized asset classes. (The number depends on who is authoring the chart, but they are roughly the same.) By democratized I’m referring to their general availability for purchase by the public. (There are other asset classes. But the public is not permitted to access them directly.)

Whew! Almost there.

Portfolio designers believe there’s an ideal allocation of each asset class to produce a desired result within the portfolio. This is called Markowitz’s “Efficient Frontier” in modern portfolio theory. For example, in a 65/35 allocation of stocks to bonds, 25% of the stocks or stock funds may be from the U.S. Large Cap class. Each portfolio design can be calculated to produce a certain mathematical return for the amount of risk built into each asset class. After all, we have lots of historical data to work with.

Last item on this: Over time, your asset allocation will drift. The percentages will be off from where you began by more than a few percentage points. This is where the portfolio must be rebalanced to its target allocation. In a non-qualified taxable account, it’s important not to create excess capital gains inadvertently so you don’t owe unplanned tax.

That’s your overview of asset allocation to create a diversified portfolio. Thanks for sticking with me.

This may make you think that there’s no way you can do this yourself. It’s too complicated and you’ll never know everything you need to know. However, if you’re determined, there are simplified offerings to help you out:

• You can choose an all-stock market/all-bond market fund and have your entire portfolio made up of these two holdings.

• In a retirement account, you can choose a Target Retirement Fund, a pre-selected diversified portfolio that changes its asset allocation as you age.

• You can use a roboadvisor.

I firmly believe that you are smart enough to understand how to design your own portfolios if you take the time to understand how to evaluate stocks and bonds and stock funds and bond funds. But now I must ask: Why would you want to if you aren’t interested in the process, only the result?

Good question.

I don’t think you should be under any obligation to manage your own investments because someone tells you it’s less expensive. You may have already determined that self-management is not for you. It’s OK if you want a financial advisor to manage your portfolio, choose the assets, do the rebalancing back to target, etc. But how do you judge that advisor?

Sometimes, you compare portfolios only to discover that your current portfolio gets a higher return but is less “efficient” to mitigate risk. Do you go with the higher return or the more risk-averse portfolio from the advisor?

That’s a tough call to make. Advisors who specialize in diversified portfolios will tell you that the real test isn’t how much the portfolio earns when the market is high, but how it behaves in a down market. Can it climb out of a hole sooner than your higher-returning, less-efficient portfolio?

As an aside, it’s my opinion that you want your advisor to do more for you than just portfolio management. Choose an advisor who will help you with tax planning, estate planning, insurance planning, education planning, etc. In other words, choose an advisor who has diversified skills and doesn’t just offer investment advice. You may pay for the investments, but it’s when they “get you” that an advisor is worth her fees.

Full disclosure: I can manage my own portfolio, yet I choose to use an advisor for two-thirds of it. I am so busy with Madrina Molly™ that I no longer have time to monitor changes to my accounts. Far be it from me to disagree with Warren Buffet, and I do have a few concentrated holdings (including Berkshire Hathaway,) but it’s no crime to be good at your own job and outsource the rest to talented specialists.

There’s a lot more to be said about asset allocation and diversified portfolios, but I’m proud of you for reading this. There are plenty of right ways to get to your financial goals. This is only one of them. Don’t let anyone tell you that their way is the only way. Diversified portfolios enable you to balance risk and reward in a proven fashion. It doesn’t make a lot of sense to assume any more risk than you need to in order to get the job done. #WeRescueOurselves #NotYoungNotDone

Copyright © Madrina Molly, LLC 2024. All rights reserved.

The information contained herein and shared by Madrina Molly™ constitutes financial education and not investment or financial advice

Sherry Finkel Murphy, CFP®, RICP®, ChFC®, is the Founder and CEO of Madrina Molly, LLC.

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