Click below to listen to Episode 28 – Diversification

Diversification

Learn more about diversification and what it really means in the financial industry.

In finance, diversification is a process of allocating capital in a way that can reduce exposure to any single asset or risk. Bob and Mary Jo breakdown the principle of diversification and all of its different aspects and look at it from various perspectives.

Often, people mistakenly think that they are diversifying assets because they are using 2-3 different financial advisors. However, diversification is about the number of non-correlated investments you use in your IRA and brokerage accounts, not about the number or advisors or various financial firms that you may use.

Jesus spoke more on stewardship than on heaven and hell combined, so God is very much in tune with how we handle money and the assets He has entrusted to us to manage on His behalf.

HOSTED BY: Bob Barber, CWS®, CKA® and Mary Jo Lyons, CFP®, CKA®

Mentioned In This Episode

Mentioned In This Episode

Christian Financial Advisors
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Bob Barber, CWS®, CKA®
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Mary Jo Lyons, CFP®, CKA®
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A Random Walk Down Wall Street by Burton G. Malkiel
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EPISODE TRANSCRIPT

[INTRODUCTION]

Bob: Welcome to Christian Financial Perspectives, a weekly podcast where we talk about ways to integrate your faith with your finances. This is Bob Barber.

Mary Jo: And I’m Mary Jo Lyons.

Bob: Are you ready to learn how to apply biblical wisdom to everyday financial decisions?

Mary Jo: Join us as we look at integrating your faith with your finances. If it’s your first time listening, welcome to our podcast, and if you’re a returning listener, welcome back.

[EPISODE]

Bob:
Proverbs 3:3-15, “Blessed are those who find wisdom, those who gain understanding, for she is more profitable than silver and yields better returns than gold. She is more precious than rubies. Nothing you desire can compare with her.”

Mary Jo:
Bob in thinking about potential topics for our show, I couldn’t help but recall how we promised our listeners we’re going to try to avoid the use of industry jargon. And when we do fall into this trap, we said that we would help our listeners break it down and explain what it means, how it fits into their financial situation, and what it has to do with their money.

Bob:
Do you know what? My wife would say amen to that. Because she says, Bob, when we go out with friends, you’re always talking in financial jargon.

Mary Jo:
We make assumptions that everybody understands what that means. But think clients that sit down in front of us. They nod their head, but a lot of times I just really think that they really don’t understand. They’re just too embarrassed to say.

Bob:
I think you’re exactly right.

Mary Jo:
Or they say, I should know what that means, but I don’t really. I think we want to take our time, spell it out, and really explain things. For example, the other day I was interviewing a potential client and they said to me, I tried to stay diversified and saved my money with several different firms. I said to myself, we need to do a better job of explaining diversification. Today, we are going to talk about diversification and how it plays into an investment portfolio.

Bob:
Now, Mary Jo isn’t that easy? Diversification is just don’t put all your eggs in one basket.

Mary Jo:
If only it was that simple.

Bob:
Seriously, for those who have been listening to Christian Financial Perspectives for some time now, you know that the Bible has a lot to say about money. In fact, it’s believed by many Bible scholars that Jesus spoke more on stewardship than on heaven and hell combined. God is very much in tune with how we handle money and the assets he has entrusted to us to manage on his behalf. Many key financial concepts are addressed in scripture.

Mary Jo:
For example, get advice from others who know more than you. This is from Proverbs 15:22.

Bob:
Which says, “Plans fail from lack of counsel, but with many advisors, they succeed.” Now let me put in a qualifying part of this. When we talk about many advisors, we’re not talking about multiple insurance advisors, multiple attorneys, multiple CPAs, multiple financial advisors. When we say many advisors, we use that scripture. We’re speaking of have a CPA, have a good insurance advisor, have a good attorney, and have a good financial advisor that’s all working as one and a team.

Mary Jo:
Certainly read up on it and do your own investigations. “Only a fool doesn’t plan ahead.” That’s another good one that comes from Proverbs 21:20.

Bob:
“The wise store up choice food and olive oil, but fools gulp there’s down.” Boy. That’s pretty straight forward there from Proverbs 21:20, isn’t it, Mary Jo?

Mary Jo:
Sure is. Another good one. “It’s good to save, invest, and multiply your holdings.” This is from Matthew chapter 25:14-30.

Bob:
This is the scripture that talks about the parable of the talents. And it’s speaking of how the manager gave one talent to one person, three to another, and five to another, and then he came back some time later and asked them what they had done with it. And one had not done anything with it. The other two had gone off, invested it, and had done a good job and said, “We’ve done well here. Here’s your talent, plus another hundred percent more.” I guess it had been a while, because investing takes a while to do that. But Mary Jo, that’s a great scripture.

Mary Jo:
It is. Depending on what version of the Bible you read, it’ll refer to talents or coins. Isn’t that correct?

Bob:
Yeah. There’s another one. I can’t remember what it is right now, but there is another thing that it refers to other than talents, but talents, I believe, back in biblical times and you take it to today, one talent equaled about $20,000.

Mary Jo:
Another good one is, “Invest in a way that’s faithful to God’s Word and that doesn’t harm others.” And this one’s from the 2 Corinthians 6:17.

Bob:
This one says, “Therefore, come out from them and be separate, says the Lord. Touch no unclean thing. And I will receive you,” which really speaks into biblically responsible investing that we’ve talked a lot about here on Christian Financial Perspectives and being careful of investing in companies that have a negative impact on our society.

Mary Jo:
And that ties into the next one. Don’t rely on money. Rely on God. And this one’s from Matthew 6:33.

Bob:
Well, Mary Jo, this is a very famous saying in the Bible. “Seek ye first his kingdom and his righteousness and all these things will be given to you as well.” Meaning, just put God first, not money.

Mary Jo:
And finally, don’t forget to have diverse holdings in order to reduce risk. This is from Ecclesiastes 11:2.

Bob:
I love this one. Solomon, one of the wealthiest men of all times, even said this, “Invest in seven ventures. Yes in 8, because you do not know what disaster may come upon the land.” To be clear, diversification is about the number of non correlated investments you use in your IRA and brokerage accounts. Mary Jo, define non-correlated real quickly.

Mary Jo:
They don’t move in tandem. They behave differently at different times in the market.

Bob:
it’s not about the number of advisors that you use or number of different financial firms you use. It’s really about having a non-correlated investment portfolio, right?

Mary Jo:
That’s right.

Bob:
Mary Jo, we often see this with people. They’re using two or three different financial advisors because they think that makes them diversified, but it really doesn’t. It says in finance that diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset class or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of asset classes. And we’re going to get into that big time today.

Mary Jo:
Yes, we’re going to be covering a lot of technical stuff today, but it’s important stuff. Let’s break it down and look at it from different perspectives. The first one is that in investing, there are two types of risk. There’s systematic risk and unsystematic risk. Systematic risk is undiversifiable risk. It’s risk that you can’t diversify away. It infects the entire market as a whole. Whereas unsystematic risk is risk that is specific to one company, one industry, or one country, or one economy. It can be reduced through diversification.

Bob:
Systematic risks are things like interest rates, war, or recession, things that affect the entire market as a whole, where unsystematic risk has to do with things like individual businesses, changing a CEO, or sales being way down or way up, and changes in supply and demand.

Mary Jo:
The market is demanding right now. You’ve seen that with all these retailers that are closing all over the place. I just read that another shoe retailer that has been around since I was a kid is closing. Obviously, the supply for their product, the demand for their product rather, has really slowed down.

Bob:
That’s an unsystematic risk. By having a diversified portfolio, we help you own investments or assets that are not correlated to each other. That’s something we really try to do. And the thought is is that when one asset has bad news, the other asset class could have good news or behave all together differently to market changes. For example, you could own stocks and real estate or stocks and bonds, or a combination of all three of these classes.

Mary Jo:
Bob, what you’re describing is what’s known as modern portfolio theory. Some of our listeners may have heard about that. It was developed by a man named Harry Markowitz in the early 1950s. It’s probably the one thing that most investment managers and advisors can actually agree on. By diversifying your portfolio, you can reduce risk. Let’s look at some of the most common ways you can diversify your portfolio.

Bob:
When it comes to the entire universe of investments, there are multiple types of investments or asset classes, but I’d say the three primary investment types are equities, or stocks is what we refer to that too, fixed income or bonds, and cash equivalents like money market instruments and CDs. But first, let’s take a deeper dive into equities.

Mary Jo:
Equities represent ownership interest in a company, whereas bonds represent debt of a company. If you own a company stock, you participate in the growth or the decline of that company. You can also generate income from your portfolios. Companies that are doing well are earning money. They’ll pay out some of that earnings in the form of a cash dividend. If you own the stock, you get to collect the dividend. If you buy bonds in a company or entity – it’s not just a company that issues bonds, but say for example, a government – we’re going to talk more about that. They also issue bonds. That’s what we mean by an entity. You’re, in a sense, loaning them money. And in return, they agree to pay you interest and return the amount of the loan or the amount of principle that they borrowed from you when the loan comes due or matures. Bonds have a maturity date. You can reinvest the dividends or interest and buy more, or you can withdraw it in the form of investment income. Bob, that’s a lot to go over. Does that make sense?

Bob:
It does. You can buy stocks in individual companies or a collection of them in what is known as a mutual fund or an exchange traded fund. There’s a big difference in these two because a mutual fund is actively managed or an exchange traded fund is not actively managed. It just owns a basket in a particular asset class, which we’re going to get into the asset classes here in a minute, but there’s a lot to consider when building a stock portfolio. For today’s discussion, let’s just talk about diversification in stocks right now.

Mary Jo:
Right. You may ask how many stocks do I need to own to have a diversified portfolio? That’s a great question. And there’s this one pretty consistent rule of thumb. It’s from a book, “A Random Walk Down Wall Street”, and there, the author explains that portfolio volatility is greatly reduced when you have as few as 20 stocks with similar weightings. And let’s look at that a little further. In other words, if you had $200,000 to invest, you could buy $10,000 of 20 different companies, but you would also want to further diversify your stock portfolio by owning companies in different industries and different market sectors. Let’s look at that little deeper.

Bob:
Okay. Mary Jo, there’s 11 commonly used market sectors for stocks. They are the energy sector and usually that’s like your oil and gas companies. The second one is the material sector, which is like containers, packaging, metals, and forest products; the industrials sector, which is like construction, machinery, airlines, road and rail. The fourth one is consumer discretionary spending. You’ll hear this talked about a lot when you’re listening to a financial show whether that’s up or down and that’s on things like clothing, travel, hotels, and restaurants and is spending going up or down there.

Mary Jo:
Right. And it’s a quick barometer of how the overall economy is doing

Bob:
It sure is. There’s the discretionary spending sector, and then you have the consumer staple sector. Now those are things that we’ve got to have like normal household products, food, beverages, then there’s the health care sector. That’s going to be your healthcare providers and services, biotechnology, pharmaceutical companies, Whoa, there’s a lot here. Financial company sector like insurance companies and banks; the technology sector like internet software, smart phones, and computing. We’re just about done. Number nine is the telecommunication services sector. That’s your wireless communications, entertainment, and internet media. Then you have your utilities, which is a place that a lot of people like to go when the stock markets are really volatile because it’s considered safer. That’s for generating, transmitting, or distributing electricity or natural gas. And that’s something we need regardless of what the economy’s doing. And then the last sector is real estate and this is where they invest in development of properties and management of them. There’s your 11 sectors that we try to diversify across and either overweight or underweight, depending on where the economy is.

Mary Jo:
As you were going through that, one of the things that occurred to me is how much some of those have changed over the years. Take the telecommunication sector. Man, that is different today than it was 25 years ago.

Bob:
Yeah. It wasn’t about wireless communications back then. It wasn’t about internet media like Netflix.

Mary Jo:
Yeah, but our young listeners, they might not even follow us. We probably shouldn’t go back there. It kind of dates us. Another thing to consider is that each of the above sectors tend to have different seasons or periods of outperformance. Again, we were speaking to that just a moment ago. It kind of depends on what’s happened in the economy to whether those sectors are doing well or are poised to do well in the future. When the economy is having a growth spurt, say, after a period of decline, materials is a sector that tends to outperform. And again, materials include building supplies like steel, lumber, and sheet rock. That makes sense that we’re going into a period of expansion. Companies that build things will be in demand.

Bob:
And then you’ve got another way to diversify – we’re getting deeper here – is to diversify your equities globally.

Mary Jo:
That’s a big one.

Bob:
It is a big one because we’re in such a global economy now, which is testimony to the tariffs and how that’s affecting things. You can own equities and companies located domestically – that’s in the United States, internationally – those companies located in foreign countries, or a combination of both. You’ll look at it like this. There’ll be one that’s called a global fund or one that’s called an international fund. And that’s what that means. International is overseas. A global can include the United States, along with international. Of course, then you have your emerging market. Let’s take that even farther. You can own stocks and companies located in developing countries like Europe and Japan, as well as emerging countries like Russia, India, Greece. These are countries who are striving to become more advanced economies, developing regulatory bodies, and creating more sophisticated market exchanges.

Mary Jo:
And they come with more risk as a result.

Bob:
Yes they do. That’s right, but hopefully a better return because it’s the risk and reward.

Mary Jo:
Yes. You can own domestic equities and foreign equities. And then equities are further broken down by market capitalization. Market capitalization refers to the total dollar market or market value of a company’s outstanding shares of stock. Market cap is calculated by multiplying a company shares outstanding by the current market price of one share of stock.

Bob:
Now, I’m sure everybody got that.

Mary Jo:
I’m sure they did, but I think we’re going to talk about it in more of a visual way that might be more helpful. There are mega companies, large companies, midsized companies, small companies, and even micro cap companies. Those are the really small ones. Let’s take a look at those in a little more detail. Bob, you want to talk about mega cap companies?

Bob:
Yeah. Those are the companies that we really recognize that are household names, and they have a market cap in excess of $200 billion. Those are companies like Walmart, Exxon, Microsoft, and Apple. Mary Jo, we want to put in here, this is not a buy or sell recommendation. We’re just giving you examples.

Mary Jo:
That’s exactly right. Large cap companies have a market cap of $10 billion to $200 billion. These include companies like Lowe’s, Conoco Phillips, and Caterpillar. And these are names you’re familiar with.

Bob:
Then we have your mid cap companies that have a market cap of $2 billion to $10 billion. These are companies like O’Reilly Auto Parts and Plantronics that we have headphones from. These are companies that have gotten beyond the small, but could be on their way to being large.

Mary Jo:
Yes. And they kind of move along this line over time. Small cap companies. These are companies with a market cap of $300 million to $2 billion. And they’re not always household names. You may not be familiar with a lot of these companies, Stag Industrial, Douglas Dynamics, Viper Energy Partners. These are just a couple of names.

Bob:
Yeah. We got the macro cap companies. These are your smallest companies. I mean, they’re still big. I mean, cause they do have a market cap of $50 million to $300 million, but there are some recognizable names here like Crocs and WD-40 company that are examples of those smaller companies. We understand this is a lot to take in, and we want you to know we’re here to be your guide and help you through all this diversification because it looks like a minefield of investment choices. You do have to be careful which one you step on, too much or too little, for your overall plan. And you can get ahold of us at Christian Financial Advisors by calling our toll free number (877) 718-7884. Again, that’s (877) 718-7884, and we can help you get through this minefield.

Mary Jo:
There’s so much to consider when building a portfolio. As advisors, what we have found is that most people, they just don’t have the time, the interest, the expertise, or the discipline to do this themselves. That’s why working with a trusted advisor is really helpful. Bob, we’ve talked about stocks. Now, let’s explore bonds in a little detail.

Bob:
Represent an IOU of a company or other type of investment. Let’s say a company wants to build a new warehouse or a state or county wants to build a toll road, but they don’t have the cash to do it. They can borrow the funds by issuing a bond where we can buy shares and in return receive interest from the issuer for the use of our money.

Mary Jo:
Just like there are many different kinds of stocks, there are also many different kinds of bonds. Let’s start with the safest one, treasury bonds. These are issued by federal governments to finance budget deficits. I think the United States has a lot of that. And these are considered risk-free since they’re backed by the taxing authority of Uncle Sam.

Bob:
Next are government bonds. And they’re just one step from that. This is a debt security issued by government to support government spending. Federal government bonds in the United States include things like savings bonds, treasury bonds, and treasury inflation protected securities called tips.

Mary Jo:
And then there’s high yield bonds. These are issued by corporations and governments with lower credit ratings. Riskier, of course, but typically they pay higher interest rates sometimes called junk bonds. Just recently, we heard a lot in the news about Puerto Rican bonds, and they were in trouble financially.

Bob:
And then there’s corporate bonds. These are issued by companies with relatively strong balance sheets for financing things like research and development and expansion, but they’re rated by the Standard & Poor’s or Moody’s Investor Services or both, and can be rated AAA, AA, A, or BBB rated. The higher the rating of an issue, the lower the probability of default.

Mary Jo:
Municipal bonds are issued by city, county, and state governments or their agencies. There are investment grade, as well as high yield options, depending on the credit worthiness of the issuer. The interest on these is tax-free, thus a good option for folks that live in high tax states like New York. If you own New York bonds and you live in New York, they’re both federally and state tax-free. Foreign bonds are issued by foreign companies, governments, or municipalities and have greater risk. What we know is geo political, as well as currency, risk.

Bob:
Bonds serve several purposes in a portfolio that can help diversify risk, but since they pay interest, they’re also used for income. A portfolio of both stocks and bonds can provide growth and income. Bonds also present some tax concerns to be aware of, municipals or fritillary tax free, and state tax free if you buy bonds in your state. Treasury bond interest is state tax free, but other US government and corporate bond interest is subject to state and federal income tax.

Mary Jo:
There are other types of bonds as well, but for the purpose of today’s show, we won’t get into too much about those. If you’d like to learn more, give us a call at Christian Financial Advisors at (830) 609-6986, and we’d be happy to talk to you about that in more detail.

Bob:
As we end today’s show, the third asset class is just that conservative cash or cash equivalents such as money markets or CDs. By diversifying your portfolio, in theory, you can reduce your risk versus owning one top of investment. How much you own of all the different types of stocks, bonds, and real estate depends on your personal goals, risk tolerance, and timeframe. This concept is what we call asset allocation.

Mary Jo:
In an upcoming episode on Christian Financial Perspectives, we will look to explore risk tolerance and timeframes and income strategies. Stay tuned.

[DISCLOSURES]

Equity investments involve risk, including the potential for loss of a part or all the principal invested. Investments are inherently risky and will fluctuate with changes in market conditions. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risk, and differences in accounting methods. Past performance cannot guarantee future results. Indexes are unmanaged measures of market conditions. It is not possible to invest directly into an index. Investing in certain securities may help to hedge against certain risks, but does not imply any guarantee from loss. There are no guarantees any investment or strategy will meet its intended objective. In general, the bond market can be volatile. The return in principle value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value. Investors should consider their investment objectives, risks, charges, and expenses associated with municipal fund securities before investing. This information is found in the issuer’s official statement and should be read carefully before investing. Income from municipal bonds may be subject to federal and or state alternative minimum taxes. To determine which investment may be appropriate for you, consult your financial, tax, or legal professional. Please remember that investment decisions should be based on an individual’s goals, time horizon, and risk tolerance. Comments from today’s show are for informational purposes only and not to be considered investment advice or recommendations to buy or sell any company that may have been mentioned or discussed. The opinions expressed are solely those of the hosts, Bob Barber and Mary Jo Lyons. Bob and Mary Jo do not provide tax advice and encourage you to seek guidance from a tax professional. Investment advisory services offered through Christian Investment Advisors Inc. DBA Christian Financial Advisors, a registered investment advisor.