I have a friend in London. He’s in the property business. And he’s a smart guy.
But he doesn’t have much experience when it comes to investing in the stock market.
He recently came by some money through an inheritance. And he wanted to invest in an equities fund of some sort.
His idea is that it will one day help pay for the education of his 2-year-old son (who happens to be my godson).
My friend got in touch with a financial advisor…let’s call him Tim… who invests on behalf of clients in different equities funds. They talked. And my friend decided to trust Tim with his son’s education fund.
My friend mentioned the arrangement to me recently. My first question was: What does Tim charge?
The answer is a rather steep 3% of the principal (my friend’s entire inheritance in other words). Then 1.5% of the principal each year for every year after that.
This covers Tim’s fees and the fees of the various funds he invests in.
These fees are way too high in my view.
In Britain you can invest in a good unit trust (the equivalent of a mutual fund) with an annual total expense ratio of as low as 0.5%.
So why hand over 3% of your money to Tim now and another 1.5% of your money every year after that for as long as you are invested?
Tim may be a good guy. He may even be a financial genius. But he’s going to have to make 2.5% extra profits on your money just to keep up with the unit trust/mutual fund that charges 0.5% a year. And he has to make an extra 1% profits every year after that.
So I asked my friend—a naturally conservative guy—why he thought Tim was worth the extra cost.
My friend said because Tim invested in different equities funds on his behalf that he felt “well diversified.”
This makes sense…on the surface.
But when I dug a little deeper into the funds Tim was investing in, the diversification story started to unravel.
First off, Tim was investing solely in equity (stock) funds. So should there be another big downturn in the stock markets like the one we saw in 2008, just being in different funds won’t make much of a difference.
Second, Tim has a high weighting of so-called ethical funds, based on my friend’s wish to favor funds that invest in environmentally friendly and ethical business.
Now, that’s my friend’s prerogative. But it means that should there be a bubble…and bust…in this type of investments, his investment will suffer.
In fact, the high fee structure Tim charges…and the lack of proper diversification…make this exactly the kind of investment I would avoid.
Paying high fees is obviously something you want to avoid.
But mistaking investing in different things for proper diversification is an even bigger threat to your savings.
Proper diversification does NOT mean investing in different stocks or different stock funds. It does NOT even just mean investing in different stocks in different countries or industries.
The definition you should use for diversification is: The less that any single bad event of any kind can affect your portfolio, the more diversified you are.
If all it takes is a big stock market crash to trigger big losses in your portfolio, you are NOT properly diversified.
Here are some basic diversification tips to help you better manage the risk of portfolio losses:
- Make sure you are diversified across asset classes as well as across geographies, sectors, etc. If you hold a lot of stocks in your portfolio, consider keeping some of your savings in cash. Cash is king when markets crash—its value increases dramatically versus financial assets. And you can be sure you won’t take any losses on your cash.
- Remember that most ETFs, mutual funds and closed-end funds give you a level of diversification because they hold a basket of assets of your behalf. ETFs usually have the lowest fee structures of all three. So use these wisely as part of your diversification strategy.
- Be wary of the traditional advice of maintaining a 60-40 stocks to bonds split. Bonds look like a very shaky investment over the long run, given the developed world’s growing debt problems. Gold is a much better diversification tool, as it will protect you in the event of a blow up in the stock market or the bond market.
- Continue to maintain a high exposure to the fast-growth, low-debt and commodities-rich economies outside the US. These give you the best prospects of capital gains over the next decade and beyond. Make sure that you don’t overweight one sector or region.
If you can keep your fees low and your level of diversification high, you’ll be doing what ALL successful investors do.