What Diversification Actually Means

Welcome once again.

It is Mr. Stillman's Opus. John Stillman here alongside Bob Payne, who joins us today. Bob is the Chief Investment Officer at Payne Capital Management in New York City. Bob, thanks for being here.

Hey, John. It's always good to be on the radio with a legend, so I appreciate the opportunity to speak to your audience today. I'm sorry that we couldn't find a legend to join you today, but maybe next week. All right.

Sounds good to me. What I wanted to talk with you about was the idea of diversification. Everybody, I think, universally agrees 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 you can give us an example of somebody who believes they have a diversified portfolio, but in reality, they don't. Well, I think I can understand the confusion, because everybody in the financial service industry talks a good game about diversification, but doesn't necessarily understand it themselves. On top of that, you might have some financial pundits.

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. If you have five stocks from five different industry sectors, you're deemed to be diversified.

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

How about that? Yeah. What would you guess would be the amount of publicly traded companies globally today?

Globally? Wow, I have no idea. It's closing in on 12,000.

Okay. So what are the chances that you're going to have next year's winner in the market owning five stocks versus owning 10,000 stocks? And if there are 12,000 stocks, how many different bonds are there? Because the bond market is even substantially bigger than the stock market, right?

Substantially bigger, but it's not as differentiated. For example, you have municipal bonds, treasury bonds, junk bonds, international bonds. They all trade basically 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 do in a stock portfolio, because there's definitely what we call negatively correlated.

Now, I hate to throw Wall Street gibberish out to 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're going to have bonds going up while stocks are going down, and you'll have stocks going up while 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 were going down.

This year you have the opposite. You have 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 there, outside of just the traditional stock and bond world? Well, let's talk about true diversification. To begin with true diversification, I think of it as four legs on a stool. You have to have these four legs to have a truly diversified portfolio, and then you've got to be diversified within those legs, 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, a fixed coupon, and a fixed 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, they're 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 they're the four legs of the stool that every portfolio should have, and that should be the initial asset test of whether or not you are truly diversified. Now, within that, you should have diversification across asset classes and within asset classes.

Yeah, so explain what we mean there. Well, 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.

Pretty easy. Well, then there's small company stocks, which over any 20-year period in history have typically outperformed large company stocks, sometimes by 100%. Now, those small company stocks are represented by an index called the Russell 2000 index. So then you have mid-sized company stocks, which again, trade differently, and typically over time give better performance than large company stocks. And even in large company stocks in the S&P 500, half of those stocks are what we call growth stocks, the other half are value stocks.

So what does that mean? Well, first of all, growth stock would be something like a Facebook or a Google, something that's growing rapidly, doesn't pay a dividend, is just growing much faster than your typical company. That's a good growth company. That's a large company growth stock. So what's a value stock?

Well, a value stock would be something like Exxon or something like Merck or JP Morgan Bank. These are old stodgy blue chip companies. They're not growing very rapidly, but they're paying a nice dividend. They typically increase that dividend every year, and they've got a giant moat around their business. So it's very hard for people to compete. They've been in business a long time and most likely will stay in business for a long time.

Now, here's a great question, Jon. Over your lifetime, what's done better, value companies or growth companies? Well, I mean, certainly a lot of the growth companies took a big hit. They took a big step backwards in the dot com crash, right? So 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.

I don't know. I mean, they're probably pretty close to even, right? You would think so, but it's hands down value outperforms growth because they don't have the bigger hits in the down years.

So that's exactly. And they have dividends and dividends that get increased and a compounding of interest in 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 you're diversified across an asset class like stocks, because over time, value outperforms growth.

Small and mid-sized companies outperform large companies, but they don't do it every year. And I think the key to diversification is to have a smooth ride. In other words, to keep the volatility down, to 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, my generation or parents' generation or 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.

In other words, have something going up while something else is going down. And even more importantly, is taking those dividends and interest and having the courage and the intelligent strategy of buying low. In other words, buying low on a relative basis in your portfolio. If you're 100% in one investment, you're not diversified. Because that investment goes down, you already own too much. So if you have small company stocks going down while large company stocks are going up, you've got 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 we're going to own it in our portfolios.

That's absolutely true, John. What I believe is a truly diversified portfolio, we only buy low-cost index funds. That way we get access to the market at the lowest cost, but we get to own basically every company out there. So not only do we own U.S. stocks and small, mid-sized growth and value, but we also invest in international companies and emerging market companies, places like China and India, where China has 1.3 billion people, India has 1.2 billion people, and as a businessman, I think about 1.3 million potential customers, or 1.2 billion potential customers, and there's 320 million Americans. So you can see the opportunity, I think, in the future is going to come from what we call emerging markets, which we all know that those markets are going to be much larger than ours in the future. So I don't know if they're still emerging.

To me, they've emerged. But if you invest across those asset classes, within those asset classes, and use index funds like we do, and you include alternative investments like real estate investment trusts and midstream energy pipelines and commodities, we basically own over 10,000 individual stocks when you break down our portfolio. And that gives us a higher probability of owning what's going to be up big next year. Again, I don't know what it's going to be.

I just know I'm going to own it. Final thing for you, Bob, and this kind of goes back to what we were talking about at the very beginning, with people thinking they're diversified when they're not. Overlap in mutual funds. A lot of people say, well, I've got 27 different mutual funds, so I'm diversified. In reality, they actually don't own that many different companies within those funds.

No, they don't. John, I just had 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 a portfolio. But when we put it through our x-ray, we put it through our 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 you can't go by the name of the fund. You've got to dig a little deeper. You've got to strip off the veneer and take a peek behind the curtain to see what they truly own.

And it's very simple to do. They just have to sit down with someone like you and have them do a portfolio x-ray, and that will tell them where the overlap occurs. Very interesting when people find out exactly what they own. Maybe every single one of their mutual funds buys Apple. I've seen that several times.

Well, it's actually true. I sat with a client the other day, a new client of ours, and when we analyzed their portfolio, they owned Apple six times. It's like buying the same car six times over.

What are you going to do, drive one every day? It doesn't make a lot of sense when you look at it 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. I really enjoyed it. Have a great day and be bullish. Absolutely. That is Bob Payne, Chief Investment Officer at Payne Capital Management in New York City, PayneCM.com if you'd like to find them online. One of the money managers that we know and trust. This is Mr. Stillman's Opus.