I don't agree when I hear investors say something like "I'd take profits on Facebook and put that money to work in Amazon". I am not using this post to judge the merits of the investment worthiness of either stock, nor the aptitude of those who say it. I simply believe moving money between stocks that are correlated is the opposite of diversification.
Birds of a feather flock together
Facebook and Amazon are part of the acronym "FANG", a popular way to describe these super popular, widely held winners of the last few years;
Facebook,
Amazon,
Netflix, and
Google (now called Alphabet). These are part of the broader cohort of tech stocks that also include Salesforce.com, Adobe, and others. The thing is, the stocks of these companies trade alike; if one is having an up quarter or year, most likely they all are. It makes individual stock selection less relevant and reinforces the notion that most of a stock's performance is correlated with the sector it's a part of. So, if you're taking a profit on Facebook stock, what's the point of putting the sales proceeds into another stock that also rose a lot? You might as well either hold onto the Facebook stock or shift the proceeds into a different sector. Or, as the old saying comes in handy; birds of a feather flock together.
Diversification done right
It's hard for a stock to outrun the gravity of its sector; not an impossibility, but a low probability.
And if you find yourself owning a particular stock for the very long term, obviously this post won't matter as much because you've accepted the ups and downs that come along with being a long term investor. Time horizon is one out of three critical objectives to take into account when developing one's overall investor profile; risk tolerance and financial goals are the other two objectives. Just to convey something known by my clients - my typical holding period for individual stocks is typically 2 to 5 years. Sometimes more and sometimes less and some positions I've been holding in clients' portfolios for over a decade.
But for the sake of this post, I want to identify the single biggest mistake I see investors make when it comes to diversification, which is also the biggest cause of substantial, permanent portfolio losses - improper diversification.
In the above Facebook/Amazon example, these two stocks may be in different sectors, social media and consumer discretion, respectively, but they are both viewed as tech stocks and are both widely held, as can be seen by their disproportionate representation in nearly every large cap stock index, ETF, and mutual fund. They both rise and fall similarly. If you are to sell one because you seek to lower your exposure to the FANG cohort, which means you presumably want to diversify your holdings, you'd accomplish that by shifting the sales proceeds into an energy, financial, or healthcare stock. In other words, stock investors need to seek diversification among different sectors. This way, if the bottom falls out from under tech stocks, going by our above example, you'd have differently correlated sectors to balance out the poor performance, thereby lessening the risk of capital losses in your portfolio. To be absolutely clear, d
iversification is a method of managing risk and doesn't protect against loss in a down market.
The single biggest risk I see today
Today, many investors who believe they are diversified are under a false sense of security because so many ETF's and mutual funds are holding the same mega-cap stocks. Add to that the individual stock holdings many investors have of "FANG et al" stocks, the over concentration potentially creates a risk quite similar to what we saw with tech stocks in the year 2000 and with financials stocks in the year 2008.
Sudden and massive financial loss is deadly
So, what got me thinking about this?
It's all about understanding baby boomers. And if you're not a boomer and you're reading this, there's a pretty strong probability your parents are boomers. I speak with boomer-aged investors' every day. They are the generation that was hit hardest by the last two severe stock market drops. Believe me when I say that as a group, they are still scarred by those market drops, which are the first things that come to their minds whenever they see the major market averages plunge; something that's been happening a lot lately.
In addition to boomer anxiety about being able to afford to retire, we now know that a big, sudden loss of wealth, a negative wealth shock, is associated with a real rise in risk of all-cause mortality, as per the Journal of the American Medical Association and conducted by Northwestern Medicine and the University of Michigan.
Financial professionals have a great deal of responsibility on their hands and now we can add the risk of life and death over our clients to the list of our responsibilities. Well, it's long been known that anxiety and stress have the potential to shorten life spans. It's also long been known that part of the job of advising clients is to be a part time psychologist. Maybe that last part will grow in scope. It's also not something an algorithm can do and possibly the one thing that stands in the way of the financial advice industry from being completely overtaken by technology. FINRA and SEC "know your customer" rules will no doubt carry extra meaning, but I know one thing for sure, my solution over here at ClientFirst Strategy, Inc. is to be a human first and a financial planner and advisor second.
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