Investing, Diversification, and Choosing a Financial Advisor

Understanding diversification in investing is very important from the standpoint of building long-term wealth and managing risk. Once you understand diversification, it can be a great first cut for finding a financial advisor who can serve you well. It’s a great assessment tool because it’s important for your advisor to have a deep and thorough understanding of diversification as a principle and an understanding that is in alignment with yours.

Understanding Diversification

The purpose of investing is to enhance financial security and the quality of life. Whether for a good retirement, philanthropy, intellectual interest, and/or something else, you’re investing for reasons. Diversification is supposed to make investing serve your greater objectives by preventing big mistakes that could sink everything.

To that end, diversification can help with “non-market risk” and not so much with “market risk.”

Let’s start with market risk. Market risk essentially is the movement in prices, positive and negative, of the stock market as a whole. Even if you owned every stock in the market, you really wouldn’t be able to shield yourself from price movements and market fluctuations.

But there’s also debate about whether market risk is important at all. If you’re persuaded as I am, by the arguments of people like Warren Buffett and Buffett’s teacher, Benjamin Graham, real risk is about actual permanent loss of capital – not price movements and market volatility. For Buffett, market risk can be avoided in large part just by waiting as long as you need to for the right investment opportunities. According to Buffett, investing should be approached as a hitter in baseball. But unlike baseball, the hitter in investing has no umpire calling balls and strikes. The hitter can stand at the plate for as long as he or she wants, waiting for the perfect pitch. In fact, the hitter can go home and come back next week or next month. If the purpose of investing is to build wealth – and to avoid losing money – over many years and decades, Buffett and Graham argue that market risk in the form of these aggregate ups and downs should simply be ignored.

On the other hand, non-market risk can be helped by diversification. Non-market risk is specific to a particular investment. Non-market risk arises from selecting an investment but neglecting to consider a factor or factors that could cause the investment to lose money. That’s less likely to happen a lot across a diversified portfolio of well-chosen investments. Some may do badly but, others may do better than expected.

The good news is that it doesn’t take a large number of stocks to create a lot of diversification and protection against non-market risk. Joel Greenblatt, a successful fund manager and Columbia University business professor, explained this concept in a terrific book he wrote in the late nineties called "You Can Be a Stock Market Genius." The statisticians he relied on believed that non-market risk is reduced:

• By 72% with a 4-stock portfolio;

• By 81% with an 8-stock portfolio;

• By 93% with a 16-stock portfolio;

• By 96% with a 32-stock portfolio;

• By 99% with a 500-stock portfolio;

So a relatively small amount of diversification potentially can eliminate a lot of non-market risks.

And here’s a final point you should keep in mind as you think about diversification. Some concentration or limit on diversification allows you to really know and research and have, potentially at least, higher confidence in the stocks you do own. Concentration in the sense of being focused, of being thorough. In one of a series of lectures at USC, Warren Buffett’s longtime business partner Charlie Munger related:

When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches — representing all the investments that you got to make in a lifetime…” He says, “Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”

Good investment ideas are rare, and for most people, investment horizons should be seven years or ten years or longer. Blending diversification with focus, mixing diversification with a disciplined process of identifying those few and far between great companies, and diversifying among those, seems like a good equilibrium to aim for.

Choosing a Financial Advisor

Once you have determined your own thinking about diversification, you can begin to evaluate financial advisors. First and foremost, engage possible advisors in conversation about their views of diversification. See if their understanding agrees with yours. If there’s not a good fit on the diversification issue, you may want to keep looking. And if there is consensus, it’s time to consider additional factors.

A marketing research firm, Spectrem, surveyed investors and asked them what their top factor was in choosing a financial advisor. The top three answers were

• Expertise 37%

• Ethical 25%

• Accountable 9%

I think the market got it right. Expertise, trustworthiness, and accountability are the big three things to look for.

When you’re looking at these three factors, here are a few considerations (with more detail in the accompanying video).

First, expertise. A credential may be an indication, but it may not be. Charlie Munger, himself, has an unconventional background. So do other, famously successful investors.

The point is, bring lots of good questions to a financial advisor you’re considering and see how the advisor thinks about your particular circumstances and aspirations.

Expertise is about what is going on inside of the advisor’s head. Expertise should be delivered in a way that connects with you intuitively, emotionally, and ideally for a long-term relationship where you’ll get guidance and hopefully wisdom all along the way. Examine how the advisor applies knowledge to your situation – how she or he connects it to your world.

Expertise also means, in my opinion, that an advisor is aware of what he or she doesn’t know. Take tax law in this country – the statutes, the court cases, the regulations. There are tens of thousands of pages. In our world of specializations, knowledge is diffuse and, experts are often an inch wide and a mile deep. A financial advisor’s expertise should include finding other sources of expertise to fully serve you as the client. Virtual teams of experts, in my experience, are often the way to go when it comes to integrating planning and wealth management. This is true in spades for my experience with business owners. Try to assess how well an advisor approaches this challenge of pulling together diffuse expertise.

Second, ethics or trustworthiness. Consider the fiduciary standard. Fiduciaries are always legally obligated to always put the client’s interest first – all the time. Registered investment advisors and their representatives are fiduciaries. In the case of broker-dealers, entities that are set up to sell rather than advise on marketable securities, the standards are murkier. The SEC has been attempting to clarify things on the broker-dealer side, but those new regulations are tied up in litigation. Ask the potential advisor about the fiduciary standard and listen to her or his answer.

Also, websites like BrokerCheck and the SEC’s investment advisor search site allow you to look up advisors and firms and see if there are red flags. Those sites shouldn’t be assumed to be definitive – there may be a skeleton that didn’t get flagged. But these are still good places to check as you conduct your due diligence.

And find out whether the custodial services used by the advisor give you 24/7 access to your account and the option for you to receive alerts on account activity like trading – important consumer protections. Finally, consider having someone you trust participate with you when you interview an advisor and/or ask a current client of that advisor for an assessment. Be sure to invest adequate time in conducting all your due diligence.

Third, accountability. In my opinion, accountability is largely about responsiveness. Ask the advisor about the ongoing process of planning and advice as you and your family progress through life and how the process will ensure that you receive timely advice.

Hopefully, focusing on these three areas will help you make better decisions.

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