diversification | Squirrelers

Diversification of Investments AND Income

We have all heard about diversification when it comes to our investments. Most people tend to believe that putting all your eggs in one basket is a highly risky approach to doing things.

This could apply on several levels. First, in terms of diversification among asset classes. For most of us, it’s probably not the best idea to be investing 100% in stocks – or bonds, or any other asset class. Even if you did diversify well, you probably wouldn’t want to put all your money in one particular investment in an asset class. For example, within stocks, you wouldn’t want to put all your money into one particular stock – diversification within asset classes is important too.

All this being said, I think we can agree that for the average person, investments ought to be effectively diversified. But what about income?

There is regular chatter among many personal finance bloggers about the value of diversifying income streams. But I wonder this: among most mainstream (non-PF Blogger) folks, why is diversification of income not seen as being as critical as diversification of investments?

Think about it – most people will not put all of their investments into one particular company. Sure, there are some who don’t believe in the concept of diversfication vs. investing in what you know, but that’s not super common. By default, if people have a 401k, they’re probably invested in many different companies by virtue of having mutual funds. Or, if they own a home, they might have some equity in place. Perhaps they have bonds, or cash. Either way, it’s highly unlikely that their investments are tied up into one single company.

However, when it comes to income, many people seem to view it differently. Frankly, I used to be the same exactly way until the last year or so. This meant looking at a job as THE source of income. Without a job, there’s no income.

Realistically, that’s probably the case with most people, I’d assume. It’s the way our society seems to be set up. However, this mindset seems to lag the sophistication we collectively have about diversification of investments. Shouldn’t income be diversified too?

If the primary source of people’s day to day money needs is their income – while savings are for retirement and other longer term needs – then it seems to make sense that income should be protected. This can happen by having a great career, but even then – you could be at the mercy of your employer, your industry, or economic conditions. So, why not diversify income sources?

Again, while many personal finance bloggers think about this, I wonder why this concept of income stream diversification isn’t has seemingly top of mind as investment diversification?

Recommendation: let’s consider it to be essential to have multiple sources of income.

If we wouldn’t invest all our savings in one company, why invest all of our income potential in one company? Let’s really take action and work on multiple streams of income in the New Year!

My Questions for You:

Why do you think it is that many people might be hesitant to invest all their money in a particular company, but will totally depend on an income stream coming from one company in employment?

Are you taking action on generating an income stream that’s different from your day job?

Home Country Bias and Investing in What You Know

By Squirrelers 18 Comments

I was talking to someone very recently about general business topics, and and we ended up briefly delving into a discussion on international markets. As a part of this discussion, I mentioned that I have been wanting to increase my exposure to non-US markets, but am currently well under 10%. My comments were that I thought I need to revisit this ratio.

The guy with whom I was talking paused for a second, furrowed his eyebrows, and then stated that he didn’t believe he had any direct international investment. He went on to comment that he’s fine with that, because how was he “supposed to know what consumers in China want?” He used China as a proxy for any market distant from the U.S. Essentially, he was saying that he didn’t understand foreign markets, so why invest in them? Right away, it seemed to me like he had a home country bias.

There’s an old maxim that you should “invest in what you know”. It’s a general philosophy that was a big part of Peter Lynch’s teachings. Lynch is probably best known for being the acclaimed manager of the Fidelity Magellan fund, as well as for authoring several popular investment books. Lynch has probably forgotten much more about investing than many of us will ever know. In other words, he knowledgeable. Clearly, Lynch achieved quite a bit of success, so there’s obviously something to the the application of this principle of investing in what you know. Furthermore, he’s just an example to point to – there are scores of investors who take this approach. Yes, just like the guy with whom I was having the aforementioned discussion.

Now, I might not be someone to dispute this approach….but then again, I’ll do it anyway:)

My view on the idea of sticking to what you know is that it has merit, but it can be misapplied and taken too far.

If somebody asks me to make a big investment in a bauxite mining operation, as an example, I’d pass. Now, it just might be a great opportunity, but since I know absolutely nothing about that business, I wouldn’t make such an investment. In that case, I’d stick to what I now, or at least avoid what I don’t know.

However, there are other legitimate examples of when it’s good to ignore the “buy what you know” approach:

Mutual Funds. If somebody asks me to make small investments across a representative set of companies traded in the stock market, I’ll think about it. Why? Well, isn’t that what index funds are, more or less? I might not know a lot about these companies, but I know enough to say that historically, stocks have earned a rate of return that well outpaces inflation. That’s enough to get me to buy stocks in a ton of different companies, all through an index funds. Index funds are a great example of how taking the “invest in what you know” approach can go too far. If you follow that approach too closely, you’d miss out on all the advantages of investing in funds. Including funds that hold positions in companies that you know nothing about.
Investing in a Company other than Your Employer. I’ve heard of several people who simply wanted to invest in the stock of their employer, because it’s what they know (or so they think). In post from the early days of the blog, I shared the story about a guy who invested everything in the company stock. He told a large gathering at a retirement party that he invested everything in the company stock over the years and that it worked for him, so we should consider doing it too. Surprisingly, he got an ovation for that. Meanwhile, I sat quiet thinking that he was so totally wrong. Maybe he got lucky with his investments, but it’s very risky to put all of one’s eggs in one basket. You already have employment risk in a company, why add investment risk too
Investing in International Stocks. This applies to the guy I mentioned above, who might want to at least consider diversification. A prior post I wrote a while ago discussed the topic of international stocks and diversification. In that post, I referenced another article which stated that at the time, the U.S. held 43% of global stock value, yet American investors hold 70% of their stock portfolios in American companies. Frankly, I’m surprised it’s that low! What’s also interesting is that the United States’ share of the world stock market value was 90% back in 1945, and has since declined to the 43% figure I mentioned above. This phenomenon of home country bias is not exclusive to the U.S. either, as it’s been seen in even more drastic terms in some other countries, as I noted in the prior post. Yes, it seems like we all need to realize that’s there’s a world out there!

My Questions for You:

Do you prefer to strictly invest in what you know, or do you branch out?

If you do branch out, do you follow each of the 3 approaches above?

Do you know anybody who carries a home country bias with investments?

Check Diversification Within International Funds

By Squirrelers 10 Comments

Most of us have heard the advice that we need to employ diversification within our broader investment portfolios. This includes diversification of asset classes, but also within classes. One of these classes is stocks.

Within each of our stock portfolios, many of us tend to have a home country bias when investing. As we discussed in a previous article, we can alleviate this by purchasing international stock funds to diversify our risk exposure.

However, we have to ask: Just how much diversification are we really getting when we invest internationally?

An interesting article in Money magazine (at CNN Money) highlights the notion that diversification isn’t as easy as it might seem, particularly due to the following factors:

Some stock markets around the world track the U.S. relatively closely
Some international stock funds are very geographically concentrated.

In terms of tracking the U.S. closely, non-North American markets rate as follows:

India: Least like the U.S.
Russia: Least like the U.S.
Japan: Least like the U.S.
East Asia: Somewhat like the U.S.
Latin America: Somewhat like the U.S.
Europe: Most like the U.S.

Interestingly, taking that into account, here are the average holdings by region in large cap foreign funds:

Europe: 61%
Japan: 15%
Latin America: 3.7%
Asia (excluding Japan): 3.2%
India: 1.1%
Russia: 0.6%

Connecting the dots, Europe correlates highest with the U.S., and represents a significant percentage of large international funds.

The article lists its own lessons. For me personally, I think the biggest takeaway is to revisit the composition of my international exposure to stocks.

I do have an individual fund in which I’m currently invested, but I haven’t checked the makeup of this fund. My previous efforts in evaluating funds focused primarily on historical performance, not it’s specific investments and source countries.

Clearly, I should take a closer look at this.

Are you have investments in international stock funds? If so, have you researched the holdings of the funds – such as geographic concentration, size of the companies, etc?

Are You as Internationally Diversified in Stocks as You Should Be?

By Squirrelers 3 Comments

As we manage our investments, many of us allocate our money across different classes: stocks, bonds, real estate, cash, and so on. Within stocks, many of us have different strategies. Some stick to index funds, some like individual stocks, some like a hybrid approach. We are all different.

But here’s a question for you: when you invest in stocks, do you first think of companies in your home country? For example, if you’re in the U.S., do you think of U.S.-based companies as the basis of your equity investments?

According to this interesting piece on Kiplinger.com, you may be guilty of home-country bias. This is where people tend to invest more in their home country stocks than they should based on percentages. For example, the article states that the U.S. owns 43% of the world’s stock market value, but U.S. investors hold 70% of stocks in American companies.

Interestingly, the are more glaring examples given. Japan holds about 10% of the worlds’ stock value, but Japanese investors focus 63% of their stock investments on home country companies. An even more extreme example from the past: in the 1980’s Sweden accounted for less than 1% of the world’s stock value, but Swedish investors – according to the article – were 100% invested in home country stocks.

To me, this is another example of people focusing too much on what they know, feeling safer about that than what they think they don’t know. This concept extends beyond the realm of domestic vs. international stocks, all the way to people investing in their employer’s stocks vs. other stocks because it’s the home team.

I have clearly seen this phenomenon in action, in one particular case from years ago, where I heard someone announce to a large gathering of coworkers at his retirement party, that he invested 100% in the company and that he recommends that we all do the same. I couldn’t believe my ears – not only by the words he said, but also by the ovation he received from much of the attendees.

Whether it’s your own employer, it’s industry, or your even home country – it’s smart to watch out for this familiarity bias.

As for myself, I have employed an index-based strategy for the most part, so I’m not showing a familiarity bias in terms of companies or industries that I personally know better. That said, I have to say that after looking at the figure above referencing the U.S. holding 43% of world stock value, I have to say that I too have shown a home country bias. I have been down in the 10% range, in terms of percentage of stocks that are international. To me, this has been something I thought about as a way to have some diversification, but I still thought of U.S. stocks as the obvious foundation of my stock investments.

As I think about this more, it may time for a paradigm shift for me. This might mean thinking globally first while leaning toward home country stocks out of loyalty, vs. what I have been doing, which is thinking U.S. stocks first and foremost with international stocks just as a token part of my investments.

What do you think? Do you have a home country bias with your investments?

Diversification vs. Investing in What You Know

By Squirrelers 5 Comments

Earlier in my career, I attended a big going away celebration for someone who was an executive at the company for which I worked at the time. I had just joined the company, and didn’t know this gentleman or his history at the company. Yet, I went to this event along with most in my department and several other closely related departments.

I can remember the scene – it was in a large auditorium-style meeting room, and there were probably at least 200 or so people in the room. The guest of honor, who was retiring, gave a speech where he recalled his proudest accomplishments at the company, shared lessons he learned along the way, thanked people who helped him achieve his success, and told a few short, funny stories. It was clear that people liked him, and that he was respected, judging by the reaction of the attendees.

Toward the end of the meeting, the guy got serious and said that he was going to share his best advice for all of us, based on his experience, that would most benefit each of us personally. The room got a bit quiet – funny how that’s the case, when the notion of individual benefits is mentioned:) Then, he told us that his best move for his family was the confidence he had in his employer, and his loyalty to it. And how did he show that? He proudly proclaimed that he took his personal investments and put it directly in the company stock. Not just some – but ALL. Yes, he invested everything he saved from his job in his company stock. He proudly, emphatically recommended that all of us do the same, and that along with our hard work will give us the same type of rewards.

Instantly, almost as if on cue, the majority of the people rose up and gave him an ovation. Heads were nodding up and down, and he was clearly seen as the loyal, good soldier who made out well. That latter part may have been the case, but not all of us gave him an ovation. Some of us – including myself and the lady next to me – were stunned and just sat there shaking our heads.

Now, I was of course happy to see someone successfully ride off into the sunset amid great fanfare and financial success. Good for him. But his advice to the crowd was flat out wrong.

He suggested putting all your eggs in one basket – the one you know best and are most closely tied to. To him, his actions were smart and honorable. To me, his actions were well-intentioned, but naive and lucky. Very Lucky.

The stock performed well over the years, increasing significantly over the time he worked there and would have made his investments. So I can see how he feels like he hit a home run – because he probably did, and I’m guessing it went way out of the park! That said, what if he took the same approach, out of loyalty, to a different employer. Let’s say that company’s stock ended up tanking. Anyone remember Enron? There were plenty of people whose personal finances were just torched by that episode.

It just doesn’t make sense to tie up a large percentage – let alone all – of one’s equity investment in one stock, out of loyalty or otherwise. Additionally, when that company also happens to be your employer, you are taking an even riskier strategy, as even more of your personal situation is directly tied to one investment.

I see how the logic could be appealing – invest in something you know very well, as opposed to investing in a wide variety of companies of which you know very little. Knowledge is better than no knowledge, it should seem.

In the case of your the equity portion of your portfolio, however, don’t invest it all in what you do know very well – your long-time employer – but invest in a diverse portfolio of companies. Index funds fit this strategy very well. Yes, I’m saying choose what you don’t know as opposed to what you do know!

Putting it all in what you know, to those that do it, seems safe. In reality, it’s a tremendous risk, in my opinion.

What’s your take? Do you feel safer by diversifying through investing in companies you may not know (index funds), or by focusing on a company that you know extremely well (employer or former employer)?