Diversify Wisely

"Diversification" is one of the most common pieces of financial advice, but what does it actually mean, and how much diversification is enough?

In this episode of The Real World Money Show, John breaks down the purpose of diversification, how it helps manage risk, and some of the common mistakes investors make when building a portfolio. He explains why diversification isn't about owning everything, but about creating a strategy that aligns with your goals, timeline, and risk tolerance.

Whether you're just getting started or reviewing an existing portfolio, this episode will help you think more clearly about balancing opportunity and risk.

Transcript

Copy Transcript Copied

SPEAKER_01 0:00

Securities and Investment Advisory Services LPL Enterprise. LPL, a registered investment advisor member, FINRA, SIPC, and an affiliate of LPL Financial. LPL and LPL Financial are not affiliated with Iron Eagle Advisors. Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. Any guests are not affiliated with or endorsed by LPL Enterprise, LPL Financial, or Iron Eagle Advisors.

SPEAKER_00 0:41

Welcome back to Iron Eagle's Real World Money Show. I'm your host, John Flick. Let me read you something, and this is from the book of Ecclesiastes, chapter 11, verse 2. Invest in seven ventures, yes, in eight. You do not know what disaster may come upon the land. That is King Solomon, writing about 3,000 years ago, giving investment advice. And here's what's amazing that one verse is the foundation of modern portfolio theory, diversification, spreading risk, not putting all your eggs in one basket. Harry Markowitz won the Nobel Prize in Economics in 1990 for developing modern portfolio theory. The idea that you can reduce risk without sacrificing returns by diversifying across multiple assets. And Solomon said it 3,000 years earlier. Invest in seven ventures, yes, in eight. You do not know what disaster may come. That is diversification, that is risk management, that's wisdom. And yet most people don't do it. They put all their money in their company stock, or all their money in real estate, or all the money in one hot stock their buddy told them about. And then disaster comes. The company goes bankrupt, the real estate market crashes, the hot stock turns out to be a scam, and they lose everything. Not because they were stupid, but because they ignored 3,000-year-old wisdom. And here's why this matters for stewardship. If you're managing resources that are not ultimately yours, you don't have the luxury of taking unnecessary risks. You can't put it all on red and hope it hits. You can't bet the farm on one investment. You have to protect what you're managing. And the way you protect it is by diversifying. Not because you're scared, not because you lack conviction, but because you're wise. You don't know what disaster may come, so you spread the risk. That's what we're going to talk about today. Diversify wisely, the third pillar of stewardship-based investing. So let's dig in. So what happens when you don't diversify? Well, let me tell you three real stories. Names are changed, but these are all real. Story number one is the Enron employee. 2001, a guy works for Enron, big energy company. Stock is flying high. Everyone thinks Enron is the future. He's got his entire retirement account in Enron's stock, about $800,000. He's 55 years old, 10 years from retirement, and then Enron collapses. Accounting fraud, bankruptcy. The stock goes to zero. $800,000 gone 10 years before retirement. He had to work until he was 75 to rebuild enough just to retire. 20 years longer than he planned, all because he did not diversify. Story number two is the real estate investor. 2006, a guy in Florida decides real estate is the path to wealth. He buys five investment properties. He takes out mortgages on all of them, rents them out. Everything is great until 2008. The housing market crashes, his tenants lose their jobs, they stop paying rent. He can't cover the mortgages. The bank forecloses on all five properties. He loses everything, and he's left with debt, all because he did not diversify. He put everything into one asset class in one geographic area. Story number three is the tech worker. 2021, a guy works for a tech startup. They give him stock options as part of his compensation. The company goes public. The stock is worth $2 million. He's 35 years old, thinks he's set for life. But he doesn't sell any of it. He keeps it all in the company's stock because he believes in the company, because his coworkers are keeping theirs and because he doesn't want to pay capital gains taxes. 2022, the tech market crashes, his stock drops 80%. $2 million becomes $400,000. Now, he's not broke, but he lost $1.6 million all because he did not diversify. So do you see the pattern? All three of these people had significant wealth and they lost it. Not because they made a bad initial investment, but because they concentrated too much in one place. Enron was a good company until it wasn't. Florida real estate was a great investment until it wasn't. Tech stocks were a great investment until they weren't. And if you're concentrated in one thing, you're one disaster away from losing everything. And that's what Solomon meant. You don't know what disaster may come, so you diversify. So now we know why. Let's talk about why it actually works. Because it's not just common sense. There's actually real math behind it. Here's the key insight: different investments move differently. When stocks go up, bonds might go down. When U.S. stocks go down, international stocks might go up. When the real estate crashes, commodities might rally. Not always, but often enough that it matters. So if you own a mix of different investments, the ups and downs can oftentimes offset each other. Your overall portfolio is smoother, less volatile, and here's the magic. You can reduce volatility without sacrificing long-term returns. Let me give you an example. Portfolio A, 100% stocks. Over the last 30 years, it returned, let's say 10% per year, but in bad years it dropped 30 or 40%. Portfolio B is 60% stocks, 40% bonds. Over the last 30 years, it returned about 8% per year, but in bad years, it only dropped 15 or 20%. Portfolio B gave you 80% of the returns with only half of the volatility, and that is diversification. You smooth out the ride without giving much up in long-term growth. And here's why this matters volatility is what makes people panic. If your portfolio drops 40%, you're tempted to sell. You're thinking, I need to get out before I lose more. But if your portfolio only drops 15%, you're much more likely to stay calm, to stick with the plan. And staying calm is how you build wealth, because people who panic and sell are the ones who lose. Diversification helps you stay calm, and that's worth more than you think. So let's go back to the Ecclesiastes 11, verse 2. Invest in seven ventures, yes, and eight. Seven, eight, not one, not two, seven or eight. Why? Because you do not know what disaster may come. Solomon's not saying spread your money around across seven ventures because you're scared. He's saying do it because you're wise. You're acknowledging that you cannot predict the future. You're humble enough to admit that any one of those may fail. But if you've got seven or eight and one fails, you're okay. You still got six or seven left. And don't get started on that six or seven. That's risk management. That's stewardship. If you're managing resources that aren't ultimately yours, you can't afford to be reckless. You can't pull it, you can't put it all on one bet and hope it works out. You have to protect the principle, you have to reduce unnecessary risk. And the way you do it is by diversifying. Not because you're timid, but because you're faithful. So Ecclesiastes 11, too, is the big one, but it's not the only place the Bible talks about spreading risk. So here's a few more examples. How about Proverbs 21:5? The plan of the diligent lead to profit as surely as haste leads to poverty. Diligence, not haste, not rushing, not putting everything on one big bet. Diligent planning means spreading risk, thinking through scenarios, not assuming everything will go your way. Remember the parable of the talents? The master gives three servants different amounts of money to manage? The first two servants invest it. They take calculated risks and they diversify and they double the money. The third servant buries it in the ground and takes no risk at all. And the master is furious with the third servant. He calls him wicked and lazy. So the Bible is not telling you to avoid all risk, it's telling you to take wise, calculated ones. And wise risk means diversification. You invest in multiple ventures. You don't bury it in the ground, but you also don't put it all on one bed. And here's one you might not have thought of. God tells Noah to build an ark, but he doesn't just say build a boat. He gives specific instructions. Different compartments, different levels, different sections for different animals. Why? Because you don't put all the animals in one room. If something goes wrong in that room, you lose everything. You spread them out, you compartmentalize, you diversify. That's risk management, even in the ark. The pattern throughout the Bible is this: take wise risks, be diligent, don't be reckless, and spread your risk across multiple ventures. That's not fear, that's not lack of faith, that's wisdom. And wisdom is a core part of stewardship. So I get it. If you work for a large company and you believe in their mission, you believe in the company, and you think they're going to be around, you may have some of their stock in your portfolio. And I and that's fine. But if your paycheck comes from that company and your retirement account is full of investments related to that same company, you're not diversified. If something happens, you lose your job, your retirement savings, all at the same time. That's concentrated risk. The rule of thumb is you should never have more than 5 or 10% of your portfolio in any single company stock, including the company you work for. You know, and here in Charlottesville, real estate has done incredibly well over the last 20 years. If you bought a house in Applemoro County in 2000, you probably have tripled your money. And because of that, a lot of people think real estate is the only investment they need. They own their house, they own rental property, maybe a second rental property, and they've got nothing in the stock market. That's concentration risk. Yes, real estate has done well, but it doesn't always do well. And if your wealth is tied up in Charlottesville real estate, you're betting that Charlottesville will continue to grow and thrive forever. And maybe it will, but you don't know what disaster may come. So you diversify. You own real estate, you own stocks, you own local, national, spread the risk. A lot of younger professionals here in Charlottesville work remotely for tech companies, then they get compensated with restricted stock units, RSUs. And those RSUs are worth a lot of money, maybe $100,000, maybe $500,000. And they keep it all in company stock because they believe in the company. They don't want to pay taxes on it yet because they think it's going to keep going up. That's concentration risk. If your company has a bad quarter, your stock drops 20 or 30%. And if you're concentrated, your net worth drops 20 or 30% as well. That's not stewardship, that's speculation. The wise move is to sell some of it. Yes, you'll pay some taxes, but you also would be diversified. And diversification is more important than avoiding taxes. And the next one is kind of sneaky. Let's say you're retired, you've got a pension, you feel secure, and you've also got a chunk of company stock in your retirement account. Here's the problem. Your pension is dependent on your company remaining financially healthy, and your stock is dependent on the company remaining financially healthy. So if the company has financial trouble, you lose your pension income and your stock value at the same time, then that's double concentration risk. The wise move is to sell the company's stock and diversify it to other investments. So your retirement income and your retirement savings are not both tied to the same institution. These are not hypothetical situations. These are real traps that real people fall into. And the solution is simple: diversification. Don't have more than 5 or 10% in any one company stock, and don't have all of your wealth in one asset class. Don't tie your income and your savings to the same institution. Invest in seven ventures, yes, in eight. So how do you actually diversify? Well, let's walk through it. Level one is asset class diversification. The first level is diversifying across asset classes. That means having some stocks, some bonds, real estate, cash. Most people should have a mix of all four. The exact mix depends on your age and your risk tolerance, but the key is you don't put everything into one. Stocks are for growth, bonds are for stability, real estate for inflation protection, and cash for liquidity. Each one does something different, and together they balance each other out. The second level is diversifying across geographies. That means U.S., international, developed markets, emerging markets. A lot of people only invest in U.S. stocks, and the U.S. has done great, but it doesn't always lead. In the 2000s, international stocks outperformed U.S. stocks. In the 2010s, U.S. stocks outperformed international. So you may not know which one will do better in the future. So own both. Maybe 60% US, 40% international, for instance, or 70-30, but you own both. The third level is diversifying across sectors. That means having some technology, some healthcare, financials, energy, consumer goods, industrials. Don't put all your money in tech stocks because if tech crashes, you're wiped out. You spread it across multiple sectors. So if one sector struggles, the others can carry you. Level four is company diversification. The fourth level is diversifying across individual companies, and this is where people get tripped up. They think they're diversified because they own five different stocks. But if all five stocks are tech companies, you're not diversified. You're concentrated in tech. Or if all five stocks are small companies, you're not diversified. You're concentrated in small caps. True diversification means owning hundreds of companies across different sectors, different sizes, different geographies. And the easiest way to do that is through index funds or mutual funds. You buy one fund and you now own 500 or maybe a thousand companies. That's diversification. The fifth level is diversifying across time. That means rebalancing. You set a target allocation, let's say 60% stocks, 40% bonds. Over time, stocks do well. Now you're at 70% stocks, 30% bonds. You rebalance, sell some stocks, buy some bonds, get back to 60-40. Why? Because rebalancing forces you to sell high and buy low. When stocks have done well, you sell some. When bonds have lagged, you buy some. That's time diversification. It's a key part of a disciplined long-term strategy. So when Solomon says invest in seven ventures, yes, in eight, here's what that looks like today. Venture one, let's call it U.S. large cap stocks. Venture two, maybe U.S. small cap stocks. Venture three, international developed market stocks. Venture four, emerging market stocks. Venture five, U.S. bonds, venture six, international bonds, venture seven, real estate, and venture eight, cash. That's seven or eight. That's diversified. And if any of those ventures fail, you're okay because you've got the others. Okay, so I've spent a lot of time telling you why diversification is important, and it is. But I need to be honest with you about something. Diversification is not magic. It is powerful, but it does have its limits. And if you don't understand those limits, you're you may very well be disappointed when diversification doesn't protect you by the way you thought it would. So let me tell you what it cannot do. It does not protect against market-wide crashes. Diversification protects you against individual company failures, it protects you against sector crashes, and it can protect you against regional downturns. But it does not protect against market wide crashes. Let me show you what I mean. 2008, the financial crisis, the housing market collapsed. Banks failed, the global economy seized up. And here's what happened to portfolios. If you were 100% in U.S. stocks, you lost about 50%. If you are diversified, 60% stocks, 40% bonds, you lost about 35%. Diversification helped, it reduced your losses, but it did not eliminate them. You still lost a third of your portfolio. But when the whole market crashes, diversification cannot save you. It can cushion the blow, but it can't prevent the blow. The 2020 example is the same thing. COVID hits, the market crashes 35% in five weeks, stocks crash, bonds hold steady, real estate drops, commodities drop. If you were diversified, you lost a lot less than if you were concentrated, but you still lost. That's the limit of diversification. It reduces volatility and it spreads risk, but it cannot eliminate systemic risk. When the whole system is under stress, everything correlates, everything moves together, and diversification does not protect you from that. Here's another limitation. Diversification does not protect you against inflation. The 1970s, inflation was running at 8%, 9%, 10% a year. Stocks struggled, bonds got crushed, real estate did okay, but not great. If you were diversified across stocks and bonds, you were losing purchasing power every year because both stocks and bonds were losing to inflation. Diversification spreads your losses, but it did not prevent them. Now, there are ways to protect against inflation, real assets, commodities, tips, real estate. But basic diversification, stocks and bonds, does not do it by itself. And here's the biggest limitation. Diversification cannot protect you from yourself. You can have the most perfectly diversified portfolio in the world, seven asset classes, 15 countries, 100 companies. But if you panic and sell when the market drops, diversification doesn't really matter. You still lose. So the investor that had in 2008 was perfectly diversified, 60% stocks, 40% bonds spread across U.S., international, small cap, large cap, everything. When the market crashed and they panicked and they sold everything in March of 2009, right at the bottom, well, his diversification didn't save him because he didn't stick with it. By the time he got back in, the market had already recovered. He missed the whole rebound. Diversification only works if you stay diversified. If you panic and abandon the plan, it's worthless. So why am I telling you this? Well, I'm pointing out the limits of diversification because I don't want you to think that it's a magic solution. It's not. Diversification is one tool. It's a critical tool, but it's not the only tool. If you want real protection, you need three things working together. One is diversification. Spread your risk across multiple investments. Two, long-term plans so you don't panic and sell when the market drops. Three, an emergency funds so you don't have to tap your investments during a crash. Those three things together, that's that offers you some real uh peace of mind. Diversification alone, it helps, but it's not enough. And this ties back to stewardship. The five pillars of stewardship-based investing are not independent, they work together. Pillar one is own nothing, manage everything, that's the mindset. Pillar two, plan long, resist short, that's the behavior. Pillar three, diversify wisely, that's risk management. Pillar four, avoid exploitation, that's the ethics. And pillar five, give generously, that's the purpose. You cannot pick just one pillar and ignore the rest. They all work together. If you diversify but don't plan long, you'll panic and sell during a crash. Diversification will not save you. If you plan long but you don't diversify, you'll get crushed when one concentration fails. You need all the pillars, they reinforce each other. So back to that 2008 lesson I was talking about. It's the perfect example. Two people, same age, same income, same portfolio size. Person A, diversified portfolio, 6040, long-term plan, 12-month emergency fund. Person B, diversified portfolios, 60% stocks, 40% bonds. No long-term plan, no emergency fund. The market crashed, both dropped 35%. Person A does not panic because she has her funds. She doesn't need to touch her investments. She has a long-term plan. She knows it's temporary. She stays the course. Person B panics because he doesn't have the emergency fund. He's worried about losing his job. He needs cash. He sells at the bottom. Person A's portfolio recovers by 2010. By 2024, it's grown to over a million dollars. Person B's portfolio never recovers because he sold. He got back in too late. By 2024, he's got half of what person A has. Same diversification. Completely different outcomes because Person A had all three protections working together diversification, long-term plan, and emergency fund. Person B only had one, and it was not enough. And here's the biblical wisdom here. Ecclesiastes 11, 2 says diversify, invest in seven ventures, yes, in eight. But that's not the only wisdom the Bible has about money. Proverbs says plan long, be diligent, don't be hasty. Joseph says build reserves, store grain during the good years so you have it during the bad ones. The Bible doesn't just tell you to diversify, it tells you to plan. It tells you to save, to be patient, to be generous. All of it works together. So here's what I want you to take away to be from this. Diversification is critical. Do it. Spread your risk. Don't put your eggs in one basket, but don't stop there. Build a long-term plan, build an emergency fund, stay disciplined. Don't panic. That's complete. That's faithful. That's stewardship. Diversification alone is not enough, but diversification plus patience plus preparation, that is how you be a good steward to what you've been given. So before we wrap up, let me tell you about the common mistakes that people make with diversification. Mistake number one is thinking you're diversified when you're not. This is a big one. You own five different mutual funds, you think you're diversified. But if all five funds own the same stocks, Apple, Microsoft, Amazon, Google, Tesla, you're not diversified. You're just paying five different expense ratios to own the same companies. The way to avoid this is to check what your funds actually own. Look at the holdings. Make sure you're getting true diversification. Mistake number two is over-diversifying. Yes, you can have too much. If you own 50 different funds, you're not more diversified than if you own five. You're just making it more complicated. And you're probably duplicating holdings and paying more in fees. The sweet spot is five or ten, enough typically, enough to cover all the asset classes and geographies, but not so many that you can't keep track of them. Mistake number three is diversifying away your returns. Some people think diversification means avoiding risk entirely, so they put everything in bonds and cash, zero stocks. That's not diversification, that's being overly conservative. Diversification means balancing risk and return. You take calculated risks with stocks and you balance it with the stability of bonds, but you don't eliminate risk, you manage it. Mistake number four is not rebalancing. You set your target allocation, say 60-40, and then you never rebalance. Ten years later, you're at 90% stocks and 10% bonds because stocks have done so well. Now you're not diversified anymore. You're all concentrated in stocks. So you need to rebalance at least once a year to maintain your target allocation. Mistake number five is chasing last year's winners. Last year's tech stocks were up, let's say 30%, so you shift all your money into tech. This year, tech crashes and you lose. That's not diversification, that's chasing performance. Diversification means you stay balanced. You don't chase what did well last year, you stick to your allocation. And here's a simple test. If one sector, one company, one asset class drops 50%, does it wipe you out? If yes, you're not diversified. If no, you can absorb a 50% loss in one area and still be okay, then you're pretty well diversified. That's the Solomon test. You do not know what disaster may come, so you build a portfolio that can survive it. So let's make this actionable. Here's what you should consider doing this week. Step one is audit your portfolio. Pull up your retirement accounts, your brokerage accounts, real estate holdings. Write down what you own and calculate what percentage of your total wealth is in each investment. If it's more than 10% of your wealth in one company stock, that's a red flag. If more than 50% is in one asset class, that's a red flag. If more than 30% is in one geographic region, red flag. Audit your portfolio, see where you're concentrated. Step two is check your company stock. If you work for a company that gives you stock, check how much you have. If it's more than 5 or 10% of your total portfolio, sell some. Diversify. Yes, you'll pay some taxes, but that's better than losing everything if the company struggles. Step three, review your fund holdings. If you own multiple mutual funds, check what they actually hold. Go to the funds website, look at the top 10 holdings, see if there's overlap. If all of your funds own the same companies, you're not diversified, consolidate or replace some of them. Step four is set a rebalancing schedule. Pick a date once a year, same time every year. On that date, you review your allocation and you rebalance. If needed, put it on your calendar, make it automatic. Step five, talk to your spouse. If you're married, have this conversation. Are we diversified? Are we concentrated in one investment? Do we need to make some changes? Get on the same page, make a plan together. Step six, if you're not sure what you're whether you're diversified or not, or if you need help building a properly diversified portfolio, give me a call. That's what I do. We help people build portfolios that are diversified across asset classes, geographies, and sectors. We'll make sure you're not taking unnecessary risks, and we help you sleep at night. That's stewardship, and that's diversifying wisely. So 3,000 years ago, King Solomon wrote, Invest in seven ventures, yes, in eight. You do not know what disaster may come upon the land. That's the foundation of modern portfolio theory. That is diversification, that is wisdom, and yet most people ignore it. They put all their money in one company's stock, or all their money in real estate, or all their money in whatever's hot right now, then disaster comes. The company fails, the market crashes, the hot investment turns cold, and they lose everything. Not because they were stupid, but because they did not diversify. If you're a steward and not an owner, you cannot afford to be reckless. You're managing resources that are not ultimately yours. You have a responsibility to protect them. And the way you protect them is by diversifying. Not because you're scared, not because you lack conviction, but because you're wise and you acknowledge that you cannot predict the future. You're humble enough to admit that any one investment may fail. So you spread the risk. You invest in seven ventures, yes, in eight. So audit your portfolio this week. See where you're concentrated and make changes if you need to. Sell some of that company stock, diversify out of that one sector, spread your wealth across multiple classes and geographies. And if you need help, give me a call. We'll help you build a portfolio that's properly diversified. Because that's what stewards do. They don't take unnecessary risk, they protect what they've been given and they diversify wisely. If you want help building a portfolio that's properly diversified, aligned with your values, and designed for faithful stewardship, give us a call. We'll help you build a plan that protects what you've been given and grows it wisely. Iron EagleAdvisors.com or 434-465-6485. This has been John Flick, building stewardship-based financial plans right here in Charlottesville, Virginia. Thank you for listening and have a great week.