They Lied To You About Diversification (The Truth Investors Won't Tell You)

Diversification. It's the golden rule of investing. You've been told over and over, spread your money around and you'll be safe. And the common belief is that if you own say 10 to 15 mutual funds or ETFs, you must be diversified. That is what Wall Street wants everyone to think. But here's the truth. That's a lie. Having a lot of funds doesn't guarantee you're safe. You might just be holding the same stocks.

For the last few decades, we've spent a lot of time uncovering the blind spots in thousands of portfolios when it comes to diversification. So today, we're going to bust the myths so that our viewers don't fall into the same traps that have cost a lot of investors millions of dollars. Today we're going to reveal five major lies about diversification and at the end we're going to show you real examples of how these lies could be affecting your portfolio.

So Phil, let's start with the first big lie and that is something that trips up most investors that we meet with. Walk us through why owning more funds doesn't always mean that you're safe.

Right. Everybody believes that if you own more and more funds, you must be diversified. It's sort of a default belief. It's a misnomer. And here's why. If you go all the way back to 1950 when Harry Marowitz created or came up with this thing called diversification or asset allocation.

Yep.

And he was the godfather to what we call modern portfolio theory and he was on to something really good that has stood the test of time. And what it said was if you are adding more and more asset classes to your investment portfolio you are highly likely to reduce risk without sacrificing performance. Well, I say that Marowitz did a great job. He got it right.

Somewhere along the way over the last 50, 60 years, we've somehow turned that into thinking that quantity gets the job done. And the fact that you have 10 or 15 mutual funds just simply done. And here's why. You can buy five mutual funds or 10 or 15 or 20, Spell, and unless you understand how to look under the hood, you can end up with those 15 mutual funds buying the same stocks.

Yeah.

And so we pull the curtain back and all of a sudden we have 15 funds on the surface looks diversified. They all have different names and they sound like they're different from one another, but they're holding the same securities.

Yep.

And that is not diversification.

No, definitely not. And it's difficult. Investing is not easy to do. It's, and achieving diversification, because there's so many different investment vehicles. There's so many different companies that bundle investments, mutual funds, ETFs. It can seem like it's almost impossible unless you have somebody who knows what they're doing and can sort of, to use a phrase that you like to use around the office a lot, look under the hood. You've got to be able to look under the hood.

Yeah. I think that is probably the best way to say it because if you never look under the hood...

Yeah.

Unless you're an expert at automobiles, you don't really understand what the power plant is. You don't know how many cylinders or what the makeup of that engine is. And so, how could you know the mutual fund? Because generally, almost like a bottle of wine, people see the wrapper on a mutual fund and they assume, okay, the name tells me what it is, right? And in some cases, it does, except that mutual fund manager by their very charter has lots of latitude. And so he or she might be investing in micro cap stocks when it is titled a large cap value fund.

Yep.

And we've seen that's where people get in trouble because they're not looking that deep. In fact, they may not have the ability to look that deep. And so they think, gosh, I've got 15 funds. My advisor told me I'm diversified. We run intersection reports or overlap studies and we can prove very quickly that you're not as diversified as you think.

Yeah. And we're going to show you exactly what Phil just mentioned, by the way. We're going to show you a stock intersection report and an X-ray or portfolio snapshot that digs into what's under the hood. So, hold on for that.

Phil, we need to move on to lie number two, and that is diversification means never losing money. Why is that a lie?

Well, go back to 2008. Go to 2008 and look what happened around the world. Not just domestically. I'm not talking about just in the US. Go around the world.

Yep.

And you saw literally non-correlated assets become highly correlated. Everything fell off of a cliff.

It's true.

And I don't think that there was a hiding place for hardly anyone.

Yeah.

And with the exception being some commodities did okay. Gold did. That would be the better class to have owned back in that, during that debacle. But let's face it, everything was highly correlated and it fell together.

Well, Phil, sometimes they say a picture is worth a thousand words. And fortunately, we have a great portfolio management team with access to the best software in my opinion on the planet. They put together a chart to explain or show exactly what you just described. So, we're going to put that on the screen now. And maybe if you just want to spend a minute or two going through the chart, and it's everything that you just said, gold may have been the only place and in addition to bonds, but everything else became highly correlated.

I think if you look at that chart, and I'm glad we have it because to your point, a picture can just say it all.

Yeah.

They say a picture is worth a thousand words and this one tells you everything. You look at this chart and everything was working well prior to that '08 calamity and you see on that chart we have emerging markets. We have international, we have domestic stocks. We have small cap, midcap. Gold is in there. And you see gold, that sort of orang-ish gold line towards the top. It still fell 18%.

It fell.

It fell 18%. Now, that's a small dip compared to the rest of the asset classes.

Yeah.

But everything on that chart from domestic to foreign, literally a global meltdown.

Yeah. So correlation became so tight among every asset class, things were falling off the proverbial cliff.

Right?

So it didn't matter which asset class you were in. What mattered is here people believe that diversification would save the day. And even if they were pretty well diversified, this was one of those parts of the cycle that just, it did not, it didn't really care about who was holding what or how diversified you thought you were.

Right. Now, I think it's important that listeners know there were plenty of mechanisms and plenty of ways to hedge against that downside.

Yep.

Even though every asset class literally was falling. Real estate was in there. That was the catalyst. Actually banks were the catalyst, but the real estate market just literally fell. It looked like it fell 30,000 ft.

Yeah.

So, but there's hedges, but the average investor doesn't know how to hedge against those kind of markets. So, that was a, I hate to use the term, that was a bloodbath.

Yeah. And that proves that diversification doesn't guarantee you won't lose money.

That's right. So huge lie. You're exactly right. Definitely a lie.

So let's go to number three. And this is that all diversification is created equal. Just like we said in lie number one, you could have an advisor telling you, I have you well diversified here. You've got your 10 or 12 or 15 funds.

And Spell, you know as well as anyone. We see that a lot, particularly, for example, if they come to us from, say, Edward Jones. It's almost a given. We know exactly what's going to be in that portfolio and then you run into things like concentration risk and there's other problems within that. But then it goes much deeper than that. So a lot of the average investor doesn't understand asset classes, right? They don't understand global assets versus domestic assets. They don't understand correlation, and everything can be either positively or negatively correlated to another thing.

True.

And so for example, Bitcoin. People say, "Oh, that's a currency." Well, it's not a currency, number one. You and I have debated this with everybody, but it's not a currency, but it's more of a growth asset.

Yeah.

Highly correlated to the S&P 500 and particularly correlated to the NASDAQ.

Yep.

And so if the NASDAQ is rallying, generally Bitcoin's rallying.

True.

If it's falling, it's going to fall with it.

That's right.

Bitcoin, that is. So there's that part of diversification. And I think that's where people make the biggest mistake. You could have 10 or 15 mutual funds, but you better carefully select them to be sure that you get reverse correlation.

That's right.

If all those managers are holding mostly individual equities, which they typically do, not alternatives, they're just holding a basket of stocks, right? And they're all buying those stocks from the same place. They have the same stocks to choose from. And so unless you're monitoring those money managers of the funds, you could easily get that highly correlated, highly overlapped strategy. But if you understand the correlation part of it, you can begin to reverse correlate that portfolio and then you do get diversification.

You might think that you're diversified or well diversified, or your advisor, your manager has said, "Well, we own 10 mutual funds. We have diversification." Ask the question, what are these funds costing me beyond just dollars and cents, by the way? So, we'll get to lie five in a second, but before we do, we got to go through lie four first. And that is your portfolio is on autopilot. Is it, Phil? Is a portfolio on autopilot? Can you just set it and forget it and never think about it again?

A lot of people do. We see that a lot in three decades of being in the wealth management world and money management world. I've also seen autopilot cost people a lot of money, right? And so autopilot, if you're in a straight-up bull market, autopilot's fine.

Can be.

Yeah. Absolutely. I've been through those phases of the market. Heck, we've seen them in recent years. And so in those cases, you could throw a dart, whatever that dart lands on in the world of stocks, right? Just buy it and you're going to be okay.

You'll do all right.

Right. Those kind of phenomenon exist, right? That can happen. What's more likely though, Spell, is when you ignore it and you put it on autopilot, what can happen is, let's say you're an investor who says, "I'm a moderate type risktaker," and let's say that their financial advisor puts them in a 7030 portfolio. Okay? And so they say 7030 is the right mix for you. If it is on set it and forget it or autopilot, let's say that we go through what we've been through in the last several years.

Oh yeah.

Where stocks have really outdone themselves, particularly the tech sector.

Oh my goodness.

The tech stocks are out of control. Valuations are off the chart. Not in all of them, but in a lot of those stocks, they're just so overvalued.

Yep. Yep.

Well, bonds on the other hand, particularly with inflation, what it did, interest rates going up to places they haven't been in 40 years, right?

Yep.

Those things caused a tremendous imbalance in that portfolio that's on autopilot. So instead of it being a 7030, in just a handful of years it might all of a sudden be an 8515. 85% stock, 15% bond.

Yep. Yep. I was going to say 7030, 70% exposure to equities, 30% exposure to bonds and cash.

That's right.

And so suddenly your exposure to risk is no longer 7030 like you thought it was. It's now 8515 and could be even more. And that's for someone who hasn't made any changes to the portfolio.

That's right. That's just the set it and forget it model. That's autopilot.

Yep.

And now is that all bad? Not always, right? If someone's 30 years old and they do that, it could work out.

Sure.

But then you go through an '08 where stocks happened to be the thing that was in the crosshairs, right? And they took an incredible hit and it took years for them to recover. Think about a person that expected to be exposed to the market around 70%. But all of a sudden they were at 85. The bleeding of their portfolio, that pain is going to be exacerbated, right? In a huge way. And there's nothing they can do about it because they didn't realize it was happening and no one was telling them.

Yeah.

So whether you're rebalancing or whether you're making tactical shifts or making certain types of adjustments, whatever they might be, and everyone's different, but unless that's happening, you can get portfolio creep where asset classes are creeping into areas that they shouldn't be based on your level of or tolerance and capacity for risk.

Phil, you made a really good point and I want to make sure that everybody understands this. You said that if you're 30 and you have your portfolio on autopilot, it might be okay. By and large I agree with that. But I would hone in on the folks who are maybe a little older, who are approaching retirement. And instead of a 30 year old having however much money put away, you're talking about people who have now spent the majority of their life putting money away. And when you don't pay attention to your allocation or the drifting that has occurred within your portfolio, you're not talking about something that you can just snap your fingers and everything will be okay the next day.

I mean, you've been through experiences with clients that it altered their life permanently because they didn't pay attention to this.

Well, because what you're describing, Spell, is a set of people who are already likely taking distributions, and so all of a sudden you have a 20 30 40% deterioration in the market. That kind of drawdown on top of someone taking five or six or 7% distribution. Yeah. Man, you get in trouble fast. And there's sometimes there's no way to recover from that. If you're 30 and you've got 30 years to go, you don't really care because accumulation's accumulation, right? Point A to point B, it's average rates of return. You don't really care what happens in the middle. You just keep putting money in.

But what a great point. So, I think depending on your age absolutely plays a huge role in how often that portfolio is rebalanced or tactically changed. Yeah, for sure.

Okay, we're gonna move on to the lie that I'm probably most excited about. This, I cannot stand this. I really cannot stand this and we hear it all the time. And that is if I have my money with multiple advisors, managers, custodians, I'm diversified. Phil, before I get overly passionate, please explain why that is a lie.

We'll get right back to today's show, but first I'd like to ask you a quick favor. If you're enjoying this episode, hit that like button and make sure that you're subscribed to our channel so you don't miss what's coming next. And hey, if something in today's episode has you wondering about your own financial plan, why not get a second opinion? Visit omnistarfinancial.com to schedule a consultation with one of our team members. It's quick, it's easy, it could make a huge difference in your financial future. Now, let's get back to the show.

If you've studied history, the Great Depression, what a cataclysmic event. It destroyed the wealth of literally everyone. Yeah. And so only the super wealthy were able to weather that storm. People got into this way of thinking that said, "Okay, well, I don't want everything at one bank. I need to broaden where I'm, I need to expand my places of holding so that if one goes out of business, I can go get my money from another one." Right. Today, we have FDIC insurance and all of those things play into that very mindset. Yep. Right.

They, and so what people learned way back when, Spell, as you well know, old habits die hard, right? People believe that if they have, say, three brokers or three advisers, three custodians, whether it's Schwab and Pershing and Fidelity maybe, or multiple banks, that somehow they're better insulated or better diversified. Now for FDIC purposes, yes, they can get better coverage that way. Yeah. But when it comes to your general investing, stocks, bonds, etc., that could not be further from the truth. That's right. It doesn't change anything.

In fact, Spell, you made this point, and you made it very well in our pre-game session. It almost hinders the way someone's trying to manage their money because there's lack of coordination. You've got one advisory group or individual potentially that is doing one thing with maybe an old employer 401k. So, it's now in an IRA. Then you've got another group that's managing, say, a brokerage account, and then maybe you have another group that's managing a different set of accounts. I don't understand how those three groups can coordinate in a way that is beneficial to the person who the money belongs to.

Well, let's be honest, they can't. Here's why, Spell. These are the things that I used to run into so often with clients. And so today, when a client says that to us, I just simply say to them, "Look, I hate to tell you this, but you're not a good fit for us because we're not going to compete with all these other people." No. And try to be coordinated.

Here's why it doesn't work. Number one, you have three brokers or three custodians. You got three competitors. Exactly. And so you got all three wanting the same thing, which is more of the money, right? And so who knows what they're saying to you. Yep. And that doesn't put the client front and center. No, that puts the client, I believe, in a position of weakness. Puts the client in the trunk. 100%.

So, number two, clients or investors all the time will say, "All right, I feel better doing it this way, more diversified, safer, totalize, right? Total misconception." But they'll say, "So, I'm going to put a little bit here and here and with you, and we'll see how each of you do and we'll see who outperforms the other one." Well, guess what that does? These three now know they're in a race and they start doing things and recommending things that probably don't fit. Yeah. What you're trying to accomplish. They're certainly not coordinated. They're not talking to one another. They're sitting over there in their little cubicle thinking, "I'm gonna win the rest of this business. I'm gonna show this client I can outperform." And they just might start taking chances that are not appropriate for that client. Very true. Horrible idea. Terrible idea.

So, but those, and that's just a few of the problems. And then, and we don't really have time to go through everything, but we could definitely make a show of this. Fees become overly complicated. Yeah. Most firms are set up so that, and ours is set up this way, the more money you have at our firm, the lower your fee goes. That's right. So you could be paying more in fees. Taxes become an issue because if you have uncoordinated accounts or distributions from those accounts, you could be costing yourself who knows how much money in taxes. That's a big problem.

So, we're not even talking about diversification in the general investing sense anymore. We're talking about diversification in your general life and how much you're spending. The fee thing by itself, people don't realize how the fees are structured, right? Smaller your account, the more you're paying. That's right. That alone could be costing people thousands and thousands of dollars a year and they don't know it and they haven't thought about it that way. So hopefully this fifth lie might help someone realize that what they thought was a good idea and diversification in an improved way is really not.

You're right, Phil. Let's move on to what we promised our listeners at the beginning. We're going to take you through a real example. We put together a portfolio that may resonate with you as a listener. And so if you've been listening or following our channel, you've likely heard our sample client, Colt and Kimber Browning. They are mid50s. They have a great household income, roughly 400,000. They've banked about $1.8 million across a couple of investment accounts. And across those investment accounts, they think they're diversified. They hold about 10 mutual funds. And so we've run a stock intersection on their portfolio to show you whether they're diversified or not.

The first point is why I run an intersection report in the first place. And people might be saying, "What the heck's an intersection report?" Sure, we refer to it as overlap. And it just means that you're holding the same stock multiple times. One of the things that people so often miss, Spell, is they can have 10 or 12 funds, but if you look at the intersection report that Spell has on the screen for you right now, you'll see that seven or eight of their 10 funds, their top holding is Nvidia. Well, who doesn't want to hold Nvidia? It's done great over the last number of years. Yes, it has almost been like a Bitcoin. But this thing has just exploded and it's done great.

But why do you need 10 funds if they're all going to hold that stock? What that tells you is your small cap managers, your international managers, they're all trying to jump into the stocks where they think they can find momentum. Yeah. Their charter, their charge is to do whatever it is that they're expert at, whether that's small cap or large cap or whatever it is. Well, Nvidia is not a small cap. Yeah. Nvidia is a mega cap stock. Oh, yeah. It's huge. Yet, you've got every type of investment or mutual fund manager buying into that stock. So that is a big problem that you can see right away. Microsoft is the second one on that chart or on that intersection report. Same thing happening with Microsoft. So that's the first point.

The second point is you end up with a lot of concentration risk. And so Nvidia in this case for the Brownings, it represents almost 8% of their portfolio. Now if it continues to run, Nvidia, then who knows? It could represent 10%. It could. Well, on the surface that looks great because people say, "Well, what's wrong with that? It's running. Nvidia is growing like mad. It's making my portfolio better." But then just think back to 2008. Yeah. What happens, or worse, think back to 2000 bubble. Yeah. A lot of our listeners may have forgotten that by now, but 2000 to 2003, we saw tech stocks fall some 75%. Yeah.

Now, if that stock represents, say, 10% of their portfolio, in this case, that'd be a quarter of a million dollars, nearly 200,000, right? Then if it falls 75%, they've just lost, of that 200, they've just lost about a whatund something like that. So just like that. Oh yeah. If that concentration risk is higher, say two or three stocks are representing 15%. Right. And in this case a lot of tech stocks are what's representing, or representative of, a big portion of the portfolio. That's right. The larger that begins, or the larger that overlap begins to present itself, and the larger the concentration, right, the greater it's going to harm the Brownings, for sure.

And Phil, just to maybe allow this to resonate a little more with our listeners, Nvidia being 8% of their entire portfolio, $1.8 8 million. You and I both know how hard Nvidia fell in April of this year. Nvidia fell 35% in one month. Even as an 8% weighting in the portfolio, because it fell 35%, their portfolio, due to Nvidia's decline, took a 3% gut punch in one month because of one position that they held. That's $50,000. $50,000.

The $50,000 hiccup that could have been avoided, could have been a lot better if they were rebalancing. That's right. And trimming positions or avoiding all this overlap, and that's the only reason that they have this concentration risk, is they think they're diversified, 10 funds. Yeah. But the fund managers have chosen to hold a lot of the same things, for sure, which exacerbates this risk, and that could be avoided. Easily avoided. It could be easily avoided.

Phil, I'm going to take it to one more spot and then we gotta wrap. But I mentioned, and you've talked about this all the time, the cost of mutual funds. And so you have, in Colt and Kimber's case, they've got 10 mutual funds in their portfolio. Keep in mind, they had an advisor as well. So, this advisor charges a fee to manage their funds. How much does the adviser charge? 1%. Okay. 1%. So, it's a 1% flat fee. So, pretty normal, by the way, for our listeners.

That's a normal rate. 1% is what you'd expect. And if you all have an adviser, if you're working with someone, chances are that's about what you're paying, right? And probably more actually, depending on the size of your portfolio. I see them all the time for one and a quarter, 1.5, even 1.6. 75. So, but let's just say one to one and a quarter. That's pretty close to industry standard, for sure.

What people don't understand is that mutual funds have what we call a hidden fee. It's not really hidden, although it can be difficult to find, but it's an expense ratio. And so we've run a portfolio snapshot that aggregates all of the mutual funds that they hold, and it tells us exactly what the average expense ratio is across those mutual funds. And Phil, before we got on camera, you and I were talking about this portfolio. The average net expense ratio on the Brownings' portfolio is 70 basis points. So that's in addition to what the manager is charging. But what are your thoughts on that?

So now your industry standard or industry average 1% is no longer 1%. No, it's 1% plus 70 basis points. So these folks are paying 170 basis points or 1.7%. Yeah. Spell, there are two things that can really drag portfolio performance. One is taxes. Yep. The other is fees. 100%. And so when you have exorbitant fees and taxes, it is going to prevent your portfolio or your investments from doing as well as they could. Yeah.

So I think in this case what our listeners need to hear, and I shout this from the rooftops all the time: if your assets, if your portfolio assets are not large enough, then mutual funds can be a great way to get started. I agree. Right. Agree. They can give you broad coverage. They can give you some diversification if done right. But I would encourage people not to go with these retail mutual funds. I would discourage that and encourage ETFs. Yep. Or I would encourage index funds when you're starting. If you know nothing else or you can't get into other things because your portfolio size is just too small, then those are great ways to start. I agree.

But when you get to a point like the Brownings have reached, 1.8 million, let's be real about this. Paying 34 of a percent nearly for these mutual funds first. You're never going to meet that mutual fund manager. Yeah. No way. They're not your friend.

They don't care. They simply care about how much they can do, how much of a bonus they get in November, and that's what they're after.

It's true.

Your advisor charging you one on top of that, and you're highly correlated, meaning you're not well diversified. What are they doing to earn that? Are they doing your tax work for you? Are they delivering comprehensive planning? Are they looking out for all the pieces that go into the financial planning process? Are they looking at all that? So, are they really earning that one?

Then you take both of those and you say, gosh, almost 2%, 1.7 in this case. If you took that portfolio, tore it apart and said, you know what, at 1.8 million, we'll use individual securities, individual bonds, and maybe some ETFs. You could take that fee, Spell, from .70 on those mutual funds. We could strip that all the way down to around 0.05 to 0.10.

Oh yeah.

So immediately the Brownings with almost $2 million shave, say, 60 basis points. That's $12,000 a year that they've saved.

That's a lot of money. $12,000.

And then depending on that advisor's value, true, it could be that they're overpaying for that. For example, with us, as you well know, you get over $3 million, your fee drops to 0.85 across the board.

That's right.

So larger assets reward you with lower fees. And getting rid of these mutual funds with all of these expense ratios can eliminate a lot of unnecessary cost.

True.

And guess what happens when you can eliminate unnecessary cost? If all things being equal, meaning performance is equal, wouldn't you rather have an extra 12,000 going towards your investments every year or more? Because that's just helping you build your net worth. Why pay it to a mutual fund manager that you never met in the first place?

So when you think of diversification, don't just think quantity, think quality. The number of funds does not equal diversification. Right? We said that throughout the show.

Nothing more true. The number of funds does not guarantee diversification. True diversification comes from something that requires much more than just grabbing a bunch of mutual funds. It requires a lot of oversight, requires someone who understands what it is that they're putting in your portfolio in the first place. And it requires ongoing presence of the mind and knowledge to know what's in that portfolio at all times.

And maybe one of the most important things that gets overlooked is you don't have to go to these mutual funds to invest. There's plenty of other things that you could use: ETFs, individual stocks, number of ways to do it. And you don't have to keep paying these high price mutual fund fees that are taking away dollars that could be working for you.

It's true. It's true. If you're not sure how your portfolio stacks up, we encourage you to not listen to the myths. There's so many of them out there. Get a second opinion. And it doesn't have to be from OmniStar. If you want it to be us, we'd be elated and thrilled and honored to do it, but it doesn't have to be us. Get somebody to run a snapshot on your portfolio. Get someone to run a stock intersection report. And if your advisor doesn't know what that is or the person you're talking to doesn't know what that is, I'd probably tell you to go somewhere else. That's a bigger problem.

Hey, check out omnistarfinancial.com. We have a place where you can request this kind of information. Our Second Opinion Solutions page will tell you everything you need to know. And sometimes we say that second opinions might be a really good place to start.

Oh yeah, second place isn't all bad is what we say a lot. And I think it's true. So you don't have to do business with us. But the second opinion could get you on a much better track. You take that to your existing advisor and tell them, look, here are the problems. I need to get this fixed. If you want to stay with them, great. But you at least need the right ammunition to understand what needs to be done.

That kind of ammunition gives you the right questions to ask. Right? If you don't have the right questions, chances are you're flying blind.

It's very true.

If you enjoyed this episode, I know you're going to enjoy the episode that Phil did on why most investors lose money every year and how you can avoid it. We'll see you next time on We're Talking Money.