One of the golden rules of investing that you often hear (and certainly it is true) is do not have all your eggs in one basket. In other words, don’t have multiples of the same investment over and over in an account. In the investment world, this is known as being diversified. Diversification is critical to having a well-balanced investment portfolio. Most people can visualize the clear and present danger to one’s retirement portfolio by not heeding this rule. It does not help you to hold the same investment in ten separate accounts. This is not diversification, you still hold the same investment. The interesting thing is how few people realize they do in fact have the same type or style of investments in their respective accounts.
Let me elaborate and explain. I recently met with a gentleman that left his 401k at his previous employer. He asked me to take a look at the investments because he thought he “had a pretty good mix,” but he wanted a second opinion. After all, his returns were in the double digits over the past few years, and as a result, he was very happy with the account (of course the broader stock market was also up by double digits over that same time period). When I looked at his account, I was not surprised by what I saw, because I see this investment strategy all the time. He may have currently been enjoying strong, positive returns since that is what the market in general was doing, but I knew he had a diversification problem as soon as he pulled his account up on the screen. How, you may ask? Simple. His retirement account consisted of five different mutual funds; however, all five had the exact same word somewhere in the title of the fund – Growth.
First, let me explain what the growth investment style means in simple terms. Growth is an investment style were the companies classified as such are typically experiencing above average growth in sales/revenues. The companies are growing faster than their peers and faster than the broader economy at large. I am not implying there is something wrong with the growth style of investing – quite the opposite. The problem is there are only so many companies that are considered growth companies. You are already eliminating some of the potential diversification an investment could have by selecting a fund that will focus on a specific part of the market.
His issue was four of the five funds were large cap growth funds (including one that had some international companies in the portfolio, not just U.S.-based companies, also known as a global fund). So what, who cares? He has several growth funds, what is the big deal? Here is the problem. When we opened the link for each fund, I was able to show him how all five funds had the same three companies in the top 10 holdings of each fund (in fact, in most of the funds, the same three companies were in the top 5 holdings). The three companies were Apple, Google, and Microsoft. This is known as overlap – having the same investments over and over again in your total, overall portfolio. I know what you may be thinking – have you seen the performance of Apple? Yes, I have. The one-year return as of yesterday was almost 38% – where is the problem? Over the past five years, the price of Apple’s stock has risen from roughly $39 per share to roughly $120 per share now.
This is a perfect example of a growth company. You are right, but here is the downside. He has five different mutual funds, however, he has a fairly good chunk of his total money in the five funds in just three total companies. What happens when the next market correction takes place? He better hope it is not in large-cap growth. He has no meaningful diversification. Five separate funds, but they are going after the same sector of the stock market, and by definition, the same companies. Remember, one of the golden rules of investing is to have different investments – diversification. Not having proper diversification is the main reason people “loose their shirt” when the stock market goes down. If all you have is one company, or one particular sector of the stock market, clearly if that company or sector goes down, you have nothing else to help balance the account value.
Diversification plays two key roles in one’s investment accounts. First of all, diversification helps reduce the investment risk in a portfolio. By default, if I have 500 different companies (think the S&P500), or if I hold just one company (think Apple), I have much less overall risk with 500 versus just one. The second way diversification helps an investor is over longer periods of time you typically will see higher rates of return. Apple may have a one year return of roughly 38% now, but just a couple of years ago the stock dropped almost 50% in 6 – 7 months. That will get your blood flowing pretty quickly.
The message here is simple. Diversify. Eliminate the overlap. Do not have all your eggs in one basket. Do have your eggs in as many different baskets as possible. Saving for retirement is not get-rich-quick, but it very much is get-rich-slow. You have to save consistently throughout your working career, and you must make sure you are properly diversified in your overall portfolio.