Diversify Across Asset Classes, Not Investment Managers
Eileen St. Pierre, The Everyday Financial Planner
One of the biggest mistakes I see many investors make, especially highly intelligent people, is confuse the concept of diversification. We all can recite the phrase “Don’t put all your eggs in one basket” but what does that phrase really mean? It means don’t put all your money in one single asset, whether it be a single stock, gold, or your home. If something bad happens to that asset, you’re left with nothing. The company could go bankrupt, your gold could get stolen, and your house can burn down right after you let your homeowner’s policy lapse. Diversification across asset classes is the key.
It is possible to be well-diversified by owning just a single mutual fund or ETF (like a life cycle or target date retirement fund) that holds a collection of stocks, bonds, and other asset classes. You’re probably thinking to yourself there’s no fun in that. The key is finding the right investment company.
Which investment company should I choose?
Many people feel that if they spread their money around to several different investment managers, they are bound to hit it big. What they don’t realize is that this can be a very expensive strategy. Many funds marketed through investment companies charge initial sales charges, called front-end loads. I’ve seen them as high as 5.75%. So if you invest $10,000 in a fund that charges 5.75% to buy in, that’s $575 for the privilege of buying that fund.
- If they would separate out the fee from your investment, many people would think twice. Would you write out a check for $575 without questioning it?
- The investment company is going to keep your $575 and only deposit $9,425 into the fund.
- If you hold this fund for 10 years and it earns an average of 8% a year, you are missing out on an additional $6,210 because of this initial sales charge.
- Are you getting your money’s worth?
- If you give your money to five different investment managers, the fees can really add up.
Choose an investment company that charges low fees and stick with that company.
In addition to front-end loads, companies can charge 12b-1 fees (0.25% to 1%) to market the fund and redemption fees to sell your fund. All funds will charge a management fee so it is important to compare management fees with funds of similar styles.
Don’t worry about not having enough funds to choose from with that company. My column Investing Basics: Mutual Funds 101 has more information on how to pick a fund. Depending on your investing goal, you can build a well-diversified portfolio with just a few funds. If I see a new client with more than five funds, I ask them why they need them all. If there is no valid reason, it may just be to increase the commission paid to the representative. Reps always seem to want you to add funds, but do any suggest selling funds? They get most of their money when you buy in.
Withdrawing your money from multiple companies can be a nightmare.
If you lose track of where all your money is, you may not be able to keep your optimal asset allocation to meet your investing goal. I’ve seen this so many times with retirement accounts.
- If you have five different accounts with five different providers, what is your overall asset allocation? You need to understand the big picture.
- When you turn age 70 ½ and it is now time to make required minimum distributions (RMDs), you will face a 50% penalty if you do not withdraw enough money.
- If all your retirement accounts are transferred to one company, making RMDs becomes so much easier.
Ok, you may have figured out by now I am a Vanguard girl. They charge some of the lowest fees in the business and provide me with more investing options than I need. No, they are not paying me to say this. I’ve had to read enough long, boring articles in my former life as a finance professor to know that active portfolio management does not work. You cannot consistently outperform the market. So I accept the risk of the market and do not expect to earn more than the market will give me. And I’m sure as heck not going to pay any more than I have to!
Visit my Basic Financial Management page for more information on investing.