Diversification: An often misunderstood term, and misused investment strategy

By BOB CUNNINGHAM

There are numerous commonly referenced words and expressions in the personal finance world, and truth be told, only a handful of them are utilized correctly.

One of the many you will hear frequently is ‘diversification.’  Most often, diversification refers to the cliche of “not putting all your eggs in one basket.” By diversifying in the investment world, you’re hedging some of your money against the possibility of poor returns in other parts of your portfolio.  You don’t invest all of your money in stocks, for example, but instead should diversify by putting part of your cash in bonds (because bonds tend to run opposite of stocks, although try telling that to those hurt the worst during the recession of nearly a decade ago, when the bottom fell out of both for a time).

Or, don’t just invest in equities.  Take part of it and go into real estate, or gold, or collectibles.  Or all of the above.  Each have their benefits and detriments, and together the idea is avoid too much exposure to one asset class in the event that the primary investment in question happens to tank.

Sounds reasonable enough, except for one thing.  Why do we really need to diversify?  Can’t we just invest conservatively in something that can’t go down, and sit back and enjoy steady, predictable growth?

We sure can, by using dividend-paying whole life insurance to hold and grow our nest-egg.  But this post isn’t specifically dedicated to insurance.  What I want to accomplish here is to illustrate why traditional, conventional saving and investing for retirement and other uses is actually counter-productive, and I’m going to use one of Wall Street’s favorite buzzwords to make my point.

Let’s say you’re convinced that the Standard & Poor’s 500 Index is about to hit the skids.  We have been blessed (?) with the long-running bull market of the modern era, but even the most optimistic of investment experts acknowledge that the run can’t last forever.  So how do you think they would react if you informed them that you believe the market is about to take a downturn, and that you’re going to exit your entire index fund and stay on the sidelines for a while, to see how it all shakes out?

“Well, uh, Mr. and Mrs. Investor, you can do that if you want to, of course, but the smart strategy would be to keep part of your money in the fund, so that you can remain diversified,” might be the reply.  “It’s impossible to know with any certainty what the market is going to do, and you don’t want to miss out on any additional growth.”

So you and your significant other counter by informing the broker that if you’re in cash temporarily, you can’t lose money except for the spending power decline due to inflation, and you don’t expect to stay away long enough for that hit to be anything that should truly matter.

“Well, if you’re uncomfortable staying with your current fund, perhaps you’d like to invest instead in our XYZ corporate bond fund?  But again, I advise you leave some of your investment dollars in the S&P,” retorts the broker.

“So you’re telling me to ignore my instinct and leave at least some money in there, so that my loss that I feel strongly is coming isn’t as significant and that I just might gain more?”

“Precisely.”

“In essence, then, it’s a coin toss… at best.”

“Well, as I said earlier, it’s impossible to know for sure what will happen.”

“Then it sounds to me like I’d be better off invested in something where I do know what will happen, even if the returns might be lower.”

“Well, uh.. um…”

PRECISELY. 🙂

You see, the basic concept of diversification is fine.  An index fund, by definition, IS diversifying because instead of investing in one or just a small group of stocks, you own a piece of every stock in the index, usually at least 50 or more.  In this fictional example, it’s the entire S&P and its 500 companies.

But investing strictly in the S&P doesn’t make much sense, because it’s still 100% in stocks and nothing else.

So what can you do to avoid this conundrum?  The aforementioned life insurance approach is the ticket.  Because you can’t lose money with this product (this assumes you purchase your coverage from one of the long-established, professional mutual carriers and not take a “discount policy” from “Larry’s Life and Health”), the need for diversification is essentially absolved.

Going this route, you invest in an instrument that will pay you a steady 4-6% net (after tax, because done correctly there is no tax) annually plus you will have a host of other advantages – living benefits – that include potentially tax-free access to at least 90% of your cash value at any time, non-qualifying loans that don’t have to be repaid AND allow your money to grow at the same rate as if you hadn’t borrowed, an asset that isn’t reported as one for income tax or estate purposes, and a strategy that is generally immune from lawsuits (seek licensed and appropriate legal counsel to assure this is correct where you live).

All of this, and a death benefit for your designated beneficiaries as well.  Now that’s what I call diversified advantages.

Thanks for reading.

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DISCLAIMER:  This post represents the author’s opinions only.  In no way should any part of the content of this post be interpreted as official financial advice, nor does it represent an intention to solicit readers into a specific company or investment.  Results are never guaranteed.  Utilize the information as you see fit, make all money decisions at your own risk.