Unnecessary risk eraser Retirement

A Guide to Avoid Crucial Retirement Planning Mistakes (Part 1)

One of the biggest mistakes you will find in a retirement planning portfolio is a lack of diversification. Learn this and other tips here.

As an investor, whether your goal is retirement planning, funding your grandchild's education, leaving a legacy for a charity, or something else, the key to success is always going be diversification. We realize we aren't breaking much new ground here—not putting all your eggs in one basket is advice doled out to investors young and old. But it is as true today as ever, and we continue to see investors shun this simple wisdom—often, unwittingly.

In today’s post, we’ll explain what we mean by diversification and provide a framework for thinking about individual security and sector diversification. In our next post, we’ll discuss global diversification and share a worksheet for you to use to determine just how diverse your portfolio is. (You might be surprised at what you find!)

Diversification for Retirement Planning

There are several different forms of diversification we think you should monitor in your retirement planning portfolio: Security-specific diversification, sector diversification and country diversification. Diversification isn't really about having a slew of mutual funds or a bunch of managers. It is about how broadly your portfolio spreads across investments that are subject to different economic factors.

Security-Specific Diversification

Security-specific diversification is the conventional wisdom that you should spread your investments across several different individual stocks or bonds. We follow the general rule that you should never have more than 5% invested in any one company or issuer. If you limit your exposure this way, then your maximum exposure in any one firm is 5% of your assets.

If you haven't (yet!) accumulated enough assets to do this in single stocks then mutual funds and ETFs are alternatives designed to do exactly this. Just make sure you know how many holdings the fund has, and what percentage is in the top 10 or 25. You might be surprised to hear it, but some funds are "focused," which is a marketing buzzword for "not adequately diversified."

While this seems very intuitive and easy to accomplish, we see many investors get tripped up just on this issue. We see lots of investors whose retirement planning strategy centers around one company's stock because Grandpa worked at the company or even founded it.  Years later, investors are still not diversified because they feel emotionally attached to the stock, or they won’t sell for fear of tax consequences. While there can be legitimate reasons to keep a stock, the reasons should be factual, not based on emotion. Concentrated positions are, purely and simply, unwise.

Another way folks violate this cardinal rule is in their bond holdings. Many folks presume bonds are safe and they don't need to diversify issuers. They buy a slew of bonds from one or two companies, or only municipal bonds issued by the state or city in which they live. Both of these examples are an enormous default risk. Simply put, if an issuer (company, municipality or other) encounters financial troubles, having exposure to their bonds threatens your retirement goals.

Our advice is to spread your bond holdings across several issuers. If you don't have sufficient capital to do this in individual securities, ETFs are a viable alternative.

Sector Diversification

If there is one lesson we hope investors creating a retirement planning strategy learned from 2000s technology bubble, it is this: Spread your investments across sectors.

While security-specific diversification is necessary, it is only step one. You see, stocks tend to trade very similarly to their peers. In 2000, Technology stocks were near-uniformly bid up to ridiculous levels, only to come crashing down. In 2008, bank stocks—almost regardless of which one—were decimated. After Energy prices fell off a cliff in late 2014, Energy stocks nearly uniformly plummeted. Exhibits 1 – 3 illustrate the point, showing the cumulative returns for stocks in these sectors during the Tech-led bear market, the Financial Crisis and the ongoing Energy-sector weakness.

Exhibit 1: S&P 500 Technology Stocks, Cumulative Return from 3/24/2000 – 10/9/2002

S&P 500 Technology Stocks, Cumulative Return from 3/24/2000 – 10/9/2002

Source: FactSet, as of 2/26/2016.

Exhibit 2: S&P 500 Financials Stocks, Cumulative Return from 10/9/2007 – 3/9/2009

S&P 500 Financials Stocks, Cumulative Return from 10/9/2007 – 3/9/2009

Source: FactSet, as of 2/26/2016. The blue dots indicate stocks that ceased trading due to merger or delisting. Returns plotted for these securities start from 10/9/2007 and end at the following: BSC, 5/30/2008; CBH, 3/28/2008; CFC, 6/30/2008; MER, 12/31/2008; NCC, 12/31/2008; SAF, 9/22/2008; SOV, 1/29/2009; WB, 12/31/2008.

Exhibit 3: S&P 500 Energy Stocks, Cumulative Return from 6/30/2014 – 2/25/2015

S&P 500 Energy Stocks, Cumulative Return from 6/30/2014 – 2/25/2015

Source: FactSet, as of 2/26/2016.

Looking at the directional similarity—and magnitude similarity, in many cases—it seems obvious that our 5% rule of security-specific diversification alone isn’t sufficient. You still may be over-concentrated in one sector.

So how do you know if you’re too concentrated by sector? Compare your weight to the broader market. For example, if you invest only in US stocks, perhaps compare your weights to the S&P 500’s sector weights. Exhibit 4 shows the weightings as of 12/31/2015. (You can also access this here—merely click on the tab labeled, “Sector Breakdown” in the box at the right.)

Exhibit 4: S&P 500 Sector Weights

S&P 500 Sector Weights

Source: FactSet, as of 2/26/2016.

The image above represents what the US market looks like on a sector basis. This is not to say you should match these weights precisely, but if you have 30% of your portfolio invested in Telecommunication Services stocks, that is an enormous overweight. You would have more than 10x as much in Telecommunications firms than the market. Similarly, you cannot merely put an equal boodle into each category. Given there are ten sectors, equal weighting would put 10% in each. That would mean skew versus the market.

We, in addition to many professional money managers, use broad, correctly constructed (market-cap weighted) indexes as a guide for retirement planning portfolio construction. If we are bullish on Health Care stocks, perhaps we’ll hold more than 15.2%. If we are not optimistic on Health Care, we’ll likely hold less—maybe 10%, which is called overweighting and underweighting.

You may be wondering why we would own any Health Care stocks if we’re not optimistic, and this is where diversification comes in to play . After all, if it was certain your optimism was correct, then why diversify at all? You have certainty! So put it all in the area you expect to do best and pop the champagne.

But that is a fantasy. In the real world, there is no certainty. You can’t know your expectations are correct, and if you totally eliminate a large sector, you take on big risk of being wrong and missing out. Similarly, we don’t recommend going hog wild in overweighting, because again, you might be wrong. Diversifying is all about being and staying humble. A humble person doesn’t overconcentrate.

A related point here is to be careful of securities that are labeled something other than stocks, but trade nearly exactly like them. For example, many brokers hawk Master Limited Partnerships (MLPs) as though they are a safe source of high dividends (something that doesn’t exist). Yet MLPs are nearly all engaged in the Energy pipeline business; hugely exposed to swings in oil prices and the risk of their customers going under if prices fall. They trade nearly exactly like Energy as a result. Since the drivers are the same, and the trade is the same, they should be added to your Energy weight. Similarly, REITs are Financials. So are Business Development Companies. Not adding these to your equity allocation means you could unwittingly skew your portfolio.

In our next installment, we’ll delve into the benefits of global investing and include a worksheet you can print off to help you assess your retirement planning portfolio’s diversification.