The Myths Surrounding Diversification And The Value Of Well-being Advisors With Meir Statman
TWC 10 | Diversification Myths

The Myths Surrounding Diversification And The Value Of Well-being Advisors With Meir Statman

The financial world can be quite overwhelming. There is so much information out there that it can be easy to get carried away by it all and forget what really matters. In this episode, Charles P. Boinske interviews Meir Statman, Glenn Klimek Professor of Finance at Santa Clara University, to help cut through the noise by breaking down the five myths about diversification and reminding us not to lose ourselves by explaining why good financial advisors are well-being advisors. He touches on strategic and tactical asset allocations and how you should think about diversifying your portfolio instead. To the second part, Meir then talks about the domains of well-being, highlighting the important things that matter—even more than investments. Join him and Charles in this conversation as they discuss more.

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I am thrilled to have as my guest, Meir Statman. He’s a Professor of Finance at Santa Clara University. His research focuses on behavioral finance through which he attempts to understand how investors make financial decisions and how those decisions are reflected in the capital markets. His most book, Behavioral Finance: The Second Generation was published by the CFA Institute Research Foundation. In this episode, Meir and I are going to discuss the five myths about diversification, as well as the concept of being a wellbeing advisor.

Meir, thank you for joining me on the show. I’m delighted to have you as a guest. I’m looking forward to having a conversation with you around two topics. The first being your article about the Myths of Stock Diversification that appeared in the Wall Street Journal. In addition to a forthcoming article, you’re publishing about wellbeing for clients of advisors.

I’m delighted to be with you, Charles.

We may start with the Wall Street Journal article that you wrote about diversification. You mentioned five myths that you think people should be aware of when it comes to diversification. Why don’t we go through those myths?

The first one I mentioned is the notion that once you have 12 or 18 stocks in your stock portfolio, you are fully diversified because you have exhausted 90% of the benefits of diversification. I say that is a myth and that is false. That is something that we all know from our tax returns. There’s a difference between our average tax return and our marginal tax return. I use an analogy of placing nineteenth gold coins in front of you. Let’s say that you have taken eighteen of them and that makes more than 94% of all the coins. The question is, should you take the nineteenth?

When considering whether you should, you compare the extra benefit, the marginal benefit of taking the nineteenth, say $1,000, which is the value of the coin, and how much does it cost you? It costs you nothing. It costs you a flick of your fingers. What it means is that you should take the nineteenth gold coin. By extension, if you have an index fund that is a total stock market index fund that has more than 3,500 stocks way more than nineteen, you should not change yourself and you should invest as broadly as possible.

When I first started my career back in the early ‘80s at Kidder, Peabody, the notion at the time was that a portfolio of twenty stocks was a widow-and-orphans portfolio, as long as those twenty stocks pay dividends and that was all you needed. You didn’t need anything else beyond that. The research in finance and academia have turned that notion on its head.

As an individual amateur investor, you have no competitive advantage. Click To Tweet

Unfortunately, even some of my academic colleagues get it wrong, but that is a separate issue. Those are other facts, not alternative facts. When you get 90% of something, the question is why not get 100% of that something if it costs you nothing to get the extra? I say go ahead and get it.

One of the things that I’ve heard over the years, and you don’t hear it as much now as I might’ve heard back in the 1990s, was that broad diversification and not trying to find the 12 or 18 stocks was un-American. It was giving up. In my view, it’s an homage to capitalism because you have all these smart people out there looking at income statements and balance sheets trying to find mispriced securities. The fact that many of them are doing that makes it difficult to pick the 12 or 18 that are going to outperform that broad portfolio. Does that square with your thinking?

Yes. I read the comments that readers post on my article, and it comes back to the same issue that is people think that if you diversify among 3,500 and more stocks, how many of those names do you know? Maybe a dozen, let alone their balance sheets, income statements and so on. People say, “If you diversify, you lose your competitive advantage.” I’m saying, “Competitive advantage? You must be kidding me.” As an individual amateur investor, you have no competitive advantage. I cannot emphasize it enough.

You have as much competitive advantage as you have at the slot machine in Las Vegas. If you stay there long enough, you’re going to lose your money. The problem is that it can happen often, whether Las Vegas or stocks that you do something stupid, and it works out. You choose an undiversified portfolio and by some luck, you end up winning and you say, “I got it,” and you continue from that. I always say, “Never argue with rich people because rich people think that they must be smart.” Sometimes rich people are just lucky.

I think that was your myth number two. The idea of owning a handful of stocks that you’ve picked is safer than buying this broad list.

That is number two and it is the notion that if you invest in something that you know, those dozen stocks, the names, the CEOs and so on, that in some way you are safer. That is about as safe as holding a tiger by the tail. It feels safe until the tiger either runs or turns on you. It is an illusion of safety, it is not safety.

Myth number three, which was owning an index fund provides you with diversification.

TWC 10 | Diversification Myths

Behavioral Finance: The Second Generation

People get the notion that index funds are widely diversified and they think that any index fund is widely diversified. Of course, it is not. If you look at the S&P 500 Index Fund, it includes 500 stocks and these tend to be large capitalizations stocks. If you hold just that, you are going to miss the small-capitalization stocks. If you’ll have a value index fund, you’re going to miss the growth ones. Sometimes, growth trounces value. Being an index fund is not sufficient. What you need is a broadly diversified index fund, such as the US total stock market fund and the international stock market fund. You can add to it a bond index fund that is broadly diversified to create a portfolio that is as diversified at a low cost as is possible.

Indexing or passive investing is a step towards a diversified portfolio, but it does not by definition create a diversified portfolio.

It is useful to be both passive and broadly diversified. They are not such that they are perfectly overlapped.

Let’s move on to number four, which is the US and international stocks are closely correlated so there’s no diversification benefit owning them both.

That is right, especially in the crisis of 2008, 2009, because both US and international went down, people said, “What’s the point?” Usually in the examples that we give is that when one goes up, the other goes down. That happens but that is fairly rare. What is more common that one goes up and the other goes up by less or by more. The gap between them is what matters. The correlation between the US and international over the past years was about 89%, which is not far from perfect 100%. If you look at year-by-year differences between the trends, they are huge. For example, in 2008, US stocks went down 37% and international stocks went down 44%. There was a 7%-point difference between the two. That’s big money. In other years, international does better than domestic. If you want to be a winner and a top investor, put everything in one stock, and you will either be a winner or a bottom investor or a loser. People say mediocrity, “I don’t want to be mediocre.” I say mediocre is wonderful. Over the long run, you’re going to be rich without having the chance that you’re going to put it in one investment if you think it’s terrific, and you’ll end up being a bottom investor and worse, you’re going to be a poor person.

That is the age-old argument that you hear all the stories about the people that were successful doing something that might have been disproportionately risky, and they didn’t even note that it was disproportionately risky. They’re putting all their money in one stock or concentrating their portfolio and having it work but the downside, the risk of that not being true can change your life in a bad way.

When you hear people tell you stories about this one stock that they chose and it happened to be Apple, or it happened to be Berkshire Hathaway, I always have this itch of saying, “May I have an audited statement of your portfolio?” I don’t say it and I’m too polite to say that, but in my mind that is what I say. Some people do put all their money at Apple at the right time. I say, “Good for you.” There are some people who go to Las Vegas and put $5 into the machine and get $1 million, but I would not advise anyone to put their last $5 on the number three and hope that they are going to be millionaires out of it.

Wise people don't get into holes that smart people can climb out of.   Click To Tweet

The fifth myth that you talked about in the argument or the article was that market timing is necessary in addition to diversification. You can diversify a portfolio, but you still need to get in and out of the market when the time is right or wrong.

Diversified portfolios are about what we know is strategic asset allocation, but there’s also tactical asset allocation where from time to time, you decide that the international stocks will do well, bonds will do well or stocks will do well and you switch accordingly. Even professionals find it next to impossible to do and that is polite. Individual investors find it impossible to do. This notion that I should have sold all my stocks at the end of 2007, then pick them up again in March of 2009, is a nice idea but it does not work. It is like driving on the highway at 100 miles an hour and say, “If something were to happen, I’m going to move the steering wheel to the left or right or I’m going to do this.” When there’s something that happened, your mind is empty, away and is panicky. You’re not going to be able to do it. If you were smart enough to take your money out of the stock market in 2007, did you put it back in on March of 2009 or did you wait and wait and watch the stock market go up? Then you’ll say, “I’ll feel such an idiot if I buy it now at a higher price than I sold it.” You get yourself all in pretzels. As they say, wise people don’t get into holes that smart people can climb out of.

My takeaway from the five myths all together is that it sounds as if you’re advocating for a broadly diversified portfolio that’s low cost, that’s in line with your overall long-term goals that you don’t radically change based on forecasts of short-term performance.

The nice thing about it on top of everything that is going to make you rich in the long run is that it involves no work. You don’t have to analyze stocks. You don’t have to figure out if the market is high or low or in between. I have work to do. I’m in finance, you’re in finance and then I do work in finance, I do research and teaching but I don’t have to pay attention to where the market is going day by day. I know that sometimes the market will go down, but in terms of actions and not results, the best policy is the policy of buy and hold low costs and leave things alone.

Also, rebalance when appropriate and manage your taxes and all those other stuff.

There are many things like managing your taxes. For example, rebalance according to your life circumstances, have a will, have a trust and so on but these are different. This is the true service of financial advisors to educate you about the market and investments, but also to deal with those things and make sure that you’ll have a will and trust that you take care of your taxes. Somehow, people find that the investment part is the sexiest part and they want to engage in it.

Let’s talk about wellbeing at a greater length. You have a forthcoming article about wealth wellbeing. I can’t recall which periodical it’s going to appear in, but let’s talk about that concept a little.

TWC 10 | Diversification Myths

The notion is that good financial advisors are wellbeing advisors. They’re not even wealth advisors because wealth is just a way station to wellbeing. If you think about the domains of wellbeing, they include family, friends, community, health, both physical and mental, work and other activities if you are retired. Money and finances underlie all of them, but having money is not sufficient. God knows in our time of COVID-19, think about what concerns us, it’s family, health, work, money, but the investment part is the smallest part. If you look at it, the market did nothing overall during 2020. It is important for you as an investor and for your advisor to focus on what matters, and what matters are those domains of wellbeing that have to do with family, health and work.

You mentioned the environment we’re in, and from my perspective having been in the industry and advising clients for a number of decades now, I’ve been through my share of good times and bad times as the rest of us out but this is an unusual period. It’s because we had a systematic problem with markets there for a while at the beginning of the year 2020, and we had a systematic problem with the healthcare system and people worried about their personal health. Two of those worries together were much greater than either of them apart. It created an unusual environment where I think it caused people to think more about the things that you mentioned, their family, their relationships, what it is that they want to do in life. That’s been the period we’ve gone through.

We know that money surely is going to promote your wellbeing. If you have millions in investments, you know that your family is going to do fine at least financially, if you are gone. If you have your health, you know that you can do whatever you want without pain. If you have work, it is not the money that you’re in, but also the camaraderie, that satisfaction and accomplishment, all of those things matter. Money underlies that but it is your role. I’m sure that you are doing that to be a teacher to your clients, to be an educator like me, to get their attention on what matters and to teach them about things like investments that they think they have understood and that they think that there is magic to them. As part of your job, you have to demystify it, to teach them about the kinds of common misperceptions, cognitive errors, emotional errors, and get them on the right path to wellbeing throughout life.

The thing that is a little bit frustrating from my perspective as an advisor, not that the clients aren’t receptive to that approach, it’s that there are many other forces in the marketplace that are undermining that on a regular basis. For example, if you turn on the television to whatever business channel you choose, there’s a well-dressed person sitting there telling you that you have to buy Apple stock or you need to get out of domestic stocks, or offering advice with no idea of how that fits in with the individual that’s listening on the program. That’s a frustrating situation to be in.

I imagine it’s more frustrating to you than to me as a professor. You turn on that television program, you see two men in suits so you know that they are experts, then one of them says up and the other says down. If I were there, I would be in a polo shirt and I would say, “I don’t know.” I was on television about Warren Buffett and invest like Warren Buffett. Warren Buffett himself says, “Invest in index funds. Don’t try to beat the market.” Your chance of being Warren Buffett is about equal to the chance of you being Roger Federer winning in tennis.

The odds are not good.

I wouldn’t play against Roger Federer if the loser pays $100,000 to the winner.

Handholding is really a lot of what a good advisor does. Click To Tweet

Meir, this has been helpful. Is there anything that we didn’t cover that you think we should have on these topics?

I think that we can talk a bit about the kinds of emotions and the kinds of cognition or cognitive errors that matter here. Usually, we talk about emotion as a synonym for emotional errors. We say, “When you invest, stay away from your emotions.” One, you cannot stay away from your emotions if you want to. Evolution did not plant emotions in you to spite you but to help you. Second, emotions help you more than emotional errors hurt you. What we can do is we can step away from our emotions and analyze them with our cognition.

The question that you have now that this is a scary time, it is scary on the investment side and it is a lot scarier in life and then the question is what do you do? If you’re afraid, you’re not alone. “What do I do?” When I’m out, I wear a mask. I keep my distance from other people even if chances are extremely good that they are not carrying the virus and I’m not carrying it either. These are the kinds of things that I do that are reasonable and that counter that sense of fear that I have. I cannot change the world, but I can behave in ways that helped me. This is one, and the other has to do with cognitive errors. Those people that we talked about, people think that they can pick stocks and so on, we described them usually as overconfident. Before they get overconfident, they are tripped by framing errors.

I mentioned Roger Federer before, and people think that trading on Robinhood or any other platform is the equivalent of playing tennis against a training ball. That’s easy, even I can do that well. The people that you trade against are not a wall. There is an opponent on the other side of the net. What will happen is that one of you is going to be an idiot. One of you is going to be the slow one and Roger Federer, insiders or professionals who specialize in Apple, IBM or any other industry and stock, you might be lucky some days but in general, they are going to win more than half of the games. One, if you frame it as tennis against the wall, you’re going to fall. You’re going to trip even before you’re overconfident.

On top of that, you have overconfidence that is some people understand that they are playing against a tennis player on the other side of the net, but they say, “I am a good tennis player. I beat all of my neighbors. Beating Federer is just one bit more.” If you do that long enough, with a casino analogy, you will end up losing, so why do that? Trading is not entertainment. This is real money. It is money that you need to support yourself, your family, for your health and for your work. Why do something stupid hoping that good luck is going to save you?

There’s some entertainment value. There’s some value that people get when they trade that is understandable. If you’re going to do it, it should be a relatively small part of the portfolio and you should acknowledge that you’re doing it for entertainment value. Is that a fair statement?

It is a fair statement. One of the readers commenting on my articles said that he invested in some small list of stocks and it worked well, but he admits that it was 2% skill and 98% luck. I would probably say it’s 100% luck, but if you know that and if you risk a small amount if you go to Las Vegas with $100 or $1,000 rather than the mortgage on your house, you’ll be fine. There will be lights, there will be noises, it is going to be great fun, but don’t carry your entire portfolio to Las Vegas. Don’t think of trading as a game, especially a game that is easy to win.

TWC 10 | Diversification Myths

Any other issues surrounding the behavioral subject or a subject matter that we should discuss?

If you think about your portfolio and the changes in your portfolio, I think it is important to realize that you and I, we don’t have attitudes towards risk. We talk about designing your portfolio 60/40, 70/30 or whatever by your attitude towards risk. I say I have no attitude towards risk. What I do have is wants, desires or goals. I have two goals. One is not to be poor and the other is to be rich. What I do is divide the money between not being poor, say bonds and being rich, which is stocks.

Over the years as I was fortunate enough to accumulate a good chunk of money, I have enough on the downside and I let my profits run. I have a high proportion of my portfolio in stocks knowing that even if stocks are decimated, I will not be poor. If I am reasonably lucky or happen to be based on historical retrials doing fine, then I’ll be able to leave a good chunk of money to my children and to causes that matter to me. For example, leaving a good chunk of money for my university, the Santa Clara University, that has been exceedingly good to me. I would like to leave some legacy for future professors and students.

I look at two conditions when it comes to the amount of risk you’re taking in a portfolio. The first condition would be one where you have enough bonds in the portfolio or have enough low-risk assets, whatever they may be in the portfolio, so that you’re not forced to sell stocks during a bad period for stocks. In other words, there’s enough there that you can meet your needs and you can see into the future far enough that over the period of time, it would take stocks to recover. You’re stable, you’re okay. The second condition would be you have such a large portfolio relative to your needs that you can invest with a longer horizon and own a lower amount of low-risk securities because you’re likely to pass those assets along to the next generation. Then there are people in between.

It is not a matter of risk. It is a matter of what you want and it is a matter of what is available in the market. For somebody who has accumulated a good chunk of money, even if the market goes down 60%, 70% or 80%, you will be fine if you also have some bonds. There are people who are retired, who have no more income other than Social Security, and who must be a lot more conservative worry more about not the poor than about being rich. You better have more bonds and less stocks. People are going to say, “You get nothing out of bonds right now.” I say, “You don’t get anything out of insurance on your house either. Every year, you shell out $1,000 and they’re gone then they asked for another $1,000.”

The point of insurance is that if something bad happens and your house goes up in flame, you’ll have money to build another house. The same applies to bonds. You have to have that even if it is yielding such a small amount, even if in real terms, it is a negative yield. Think about it as insurance. Because people do their mental accounting in nominal terms, they don’t notice that in the good old days, when you can get 10% on your money market fund, inflation was running at 12% and you were 2% behind in real terms. On top of that, you don’t have to pay taxes on 10%. Comfort yourself knowing that if you earn zero interest, you’ll pay zero tax on it.

I distill all the comments that you’ve made. It sounds like to me what you’re advocating for is broadly diversifying a portfolio, keeping it low cost and then making sure that portfolio dovetails with your wants and needs.

Get a good and wellbeing advisor because you’re going to find yourself scared from time to time, you’re going to find yourself baffled many times. You need somebody to go to who is going to explain what is going on and advise you what actions, if anything to take. That advisor is going to look at your life as a whole and advise you about these things as well, advise you about work, “When can you retire? Do you want to retire?” They will advise you about the need to have a will and perhaps even about what to do.

The value of an advisor is not in beating the market. It is really in enhancing your well-being.   Click To Tweet

If a client comes and says, “My oldest son made me angry, I think I’m going to write them out of my will,” I think that they’re likely to hear from an advisor, “Why don’t you sit on it for two weeks and see how you feel because at some point, you are going to go and the last thing you want is to leave behind the family that splinters apart?” The job of an advisor is a difficult one. Teaching as I do is one portion of it. Handholding is a lot of what a good advisor does. I think that it is important for clients to understand that the value of an advisor is not in beating the market, it is in enhancing your wellbeing.

That sounds like a great place to stop for this show. I hope you’ve enjoyed the conversation. I would like to have you back in the future to talk about maybe Behavioral Finance in some more depth and maybe whatever research you’re working on at that point in time. I appreciate the fact that you’ve joined us. I think you’ve added a lot of value to the audience. Thank you very much.

Thank you, Charles. It was a delight to speak with you.

Thank you for joining Meir and me as we discuss the five myths of diversification as well as the concept of being a wellbeing advisor. I’ll look forward to the next time, until then be well.

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About Meir Statman

TWC 10 | Diversification MythsMeir Statman is the Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University and Visiting Professor at Tilburg University in the Netherlands. His research focuses on behavioral finance. He attempts to understand how investors and managers make financial decisions and how these decisions are reflected in financial markets.

The questions he addresses include: What are the cognitive errors and emotions that influence investors?  What are investor aspirations?

How can financial advisers and plan sponsors help investors? What is the nature of risk and regret?  How do investors form portfolios?  How successful are tactical asset allocation and strategic asset allocation?  What determines stock returns?  What are the effects of sentiment? How successful are socially responsible investors?

Meir’s research has been published in the Journal of Finance, the Journal of Financial Economics, the Review of Financial Studies, the Journal of Financial and Quantitative Analysis, the Financial Analysts Journal, the Journal of Portfolio Management, and many other journals.  The research has been supported by the National Science Foundation, the Research Foundation of the CFA Institute, and the Investment Management Consultants Association (IMCA).  Meir is a member of the Editorial Board of the Financial Analysts Journal, the Advisory Board of the Journal of Portfolio Management, the Journal of Wealth Management and the Journal of Investment Consulting, an Associate Editor of the Journal of Financial Research, the Journal of Behavioral Finance, and the Journal of Investment Management and a recipient of a Batterymarch Fellowship, a William F. Sharpe Best Paper Award, a Bernstein Fabozzi/Jacobs Levy Outstanding Article Award, a Davis Ethics Award, a Moskowitz Prize for best paper on socially responsible investing, two Baker IMCA Awards, and three Graham and Dodd Scroll Awards.  Meir consults with many investment companies and presents his work to academics and professionals in many forums in the U.S. and abroad.

Meir received his Ph.D. from Columbia University and his B.A. and M.B.A. from the Hebrew University of Jerusalem.

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