Building A Diversified Portfolio For The Long Term
Warren Buffett, one of the world’s greatest investors, said;
“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”
Many financial advisors recommend that you diversify for your own protection. What they fail to tell you is that it is also for their protection. Since most financial advisors cannot tell you exactly which stock or mutual fund is a great investment, they tell you to buy a bunch of them.
The reality is that what the general public thinks of when they hear diversification isn’t real diversification at all. Instead, it’s putting all your eggs in different parts of the paper-asset basket.
Diversification keeps you from “putting all your eggs into one basket,” so if one industry collapses—as tech did famously in 2000—only a portion of your portfolio will be affected.
You might remember Jim Cramer, a very smart investor and an expert on the stock market, ran a segment on his TV program called Am I Diversified? During that segment, viewers called in and rattled off the stocks they are holding in their portfolios. For example, a viewer might have said, “I have shares of Exxon, GE, IBM, Procter and Gamble, and Bank of America. I also have an emerging market fund, money market fund, a gold ETF, a bond fund, a REIT, an S&P 500 index fund, and I just bought an index fund for large-cap dividends. Am I diversified?” Jim Cramer would then evaluate the viewer’s diversified portfolio.
In my opinion, the above portfolio is not diversified.
It is de-worsified.
It is less worse, but not diversified because it is filled with only one class of assets: paper assets. If the stock market crashes, which it will, diversification will not protect him.
When everything you’re invested in is still on paper, it’s based on the same fragile economy and the same investment model. When the stock market goes down, it goes down everywhere, not just in certain places. Investing in Microsoft and McDonald’s won’t make any difference if the market tanks and everything goes down. Widely investing in different mutual funds spreads that risk around even more, but the risk is still the same and the hit will be the same when things go south.
Everyone Became An Investor
This brand of diversification seems to have been created when the rules changed in 1974 with the passage of the Employee Retirement Income Security Act (ERISA), which eventually gave birth to programs such as the 401(k).
Prior to this, employees could expect to get a paycheck for life from their employer after they retired, thanks to their defined benefit (DB) retirement plan. But after 1974, employers started moving employees from DB plans to defined contribution (DC) plans, which forced millions of people to become investors without the necessary education.
As a result, suddenly, people without much financial education became “professional financial advisors” pushing “a diversified portfolio.” School teachers, used car salesmen, housewives, and insurance agents found new careers as financial advisors selling investments to people just like themselves. This was a big boost to the financial services industry, which had set out to hire thousands of people to service this new group of employees who needed to become investors.
Financial advisors essentially were and are the henchmen of banks and mutual funds to sell you their products, take your money, charge you fees, and use your money to get richer. When they talk about being diversified, what they really mean is spreading your money around one asset class—paper assets. And when the paper asset markets crash, you lose.
Four Asset Classes
True diversification is investing across different asset classes, not different stocks. This holds true with any of the asset classes. If I’m invested in condos, apartments, and houses, my portfolio looks diverse, but they’re all still real estate assets. So, I have real estate assets, commodities assets like gold and silver, business assets like my companies, and yes, I have some paper assets as well. But I know they’re not going to make me rich.
True diversification is investing in all four asset classes, which are:
- Business: Owning a business that creates cash flow.
- Real estate: Having investment properties that create cash flow.
- Paper assets: Trading paper assets with technical investments.
- Commodities: Hedging against markets with commodities such as gold, silver, oil, and more.
As an investor, you should be in all four asset classes, and you should be specializing in one or two. Most people are only invested in paper assets, and they have no knowledge about what they’re investing in, so they listen to financial planners and hold a basket of paper assets for the long term, hoping the market goes up. If you want to be rich, however, it’s a bad idea.
Financial Education Is The Path To True Portfolio Diversification
As a young man, my rich dad said to me, “If you are going to be successful in the real world, you and your generation will need more than just academic and professional education.”
Rich dad was speaking, of course, about financial education. Financial education is about how money works and how to make it work for you. It teaches you about debt and how to leverage it, the history of money, what a financial statement is and how to read it, the difference between an asset and liability, and so much more.
If a person has no financial education, they cannot process information. They do not know the difference between an asset or a liability, capital gains or cash flow, fundamental investing or technical investing, why the rich pay less in taxes, or why debt makes some people rich and most people poor.
They do not know a good investment from a bad investment, or good advice from bad advice. All they know is to go to school, work hard, pay taxes, live below your means, buy a house, get out of debt, and die poor.
As the Bible states, “My people perish from a lack of knowledge.” Today, millions are perishing because all they have been trained to do is send their money to the rich and to the government.
That is not education.
Editor, Rich Dad Poor Dad Daily