Episode 60 – Does Diversification Work? Warren Buffet Does Not Think So!


Warren Buffet says that diversifcation is for the ignorant. Pretty strong words, right?

In this episode, we talk about diversification and why so many advisors push it.

Hi everyone and welcome to another wealthy and wise Wednesday and I hope your week is going great for you and let’s see just a couple of more days to the weekend, hope you got some good plans, hope where you are at the weather is good? I think right now we have been in some record heat so it has been most welcome to jump in the pool or the lake and to cool off a little bit.

[00:00:34] So this week, I want to talk to you about a couple different things. You know when I first started in this business, I had this manager, this district manager, if you will and he was kind of in charge of me and what he would do is help me make sure that I was doing the correct thing for clients when they came, kind of looking over my shoulder. And I had been doing a little bit of marketing and ran in to some an older couple, he had retired a couple of years ago and they didn’t really have any kind of financial adviser and they were wondering what kind of thing they should do.

[00:01:15] so I spent significant amount of time with them, we talked about where their money is currently, we talked about their risk tolerance. If they were risked based or trying to be a little more conservative. Now, keep in mind this is the 80s, so in the mid to late 80s, markets are just going crazy, it doesn’t seem like they ever going to end, everybody has been making money, interest rate has been dropping since the late 70s. Inflation has been dropping since the late 70s and as a whole, with what is going on in the economy and politically even it looks like we are going to keep running on forever.

[00:02:01] seems like we do this about every decade, right, it happened again in the 90s, it happened in 2000, I mean it just seems to occur about as Buffet says about every 10 years. So I was talking to these folks, made you know pretty good junk of money and I was trying to do the traditional financial planner thing and make sure that they were completely diversified and the had the correct allocation and all that good stuffs. But what I was a little bit shocked about is all the different investment alternatives that just really are not very client friendly. In fact, they just downright stinks.

[00:02:52] But I am the new guy, I don’t know any difference, so I am talking with my manager, he is trying to help me make sure I put together good portfolio for these people. What we essentially do is we market wise, we buy some mutual funds then we even get some bonds just for the diversification, all that good stuffs. Then finally, he starts putting some of their money into limited partnerships. Now for those of you who don’t know what limited partnerships are. These are investments that you can get in to and they had different objectives, one might be based around oil and gas. One might be based around in this case cable, TV systems.

[00:03:43] Some might be based around real estate. It is just a whole varieties of limited partnership out there. We have seen equipment, all kind of stuff. Anyway, so he started picking four or five limited partnership. Now, here is the downside to limited partnerships, one is they are very ill liquid. In fact, to go and get out of the limited partnership, you have to go out to what I call the vulture market where they just discount your limited partner shares down to penny so that you can get out. The problem is you will never get out with anywhere near what you started with.

[00:04:25] So it is a horrible market and it just never going to be somewhere where you can go on the secondary market and sell your shares whenever you want such as you can with the stock or bond. So, they are very ill-liquid, the other thing is they are some of the highest fees you will ever see. It is not uncommon for limited partnership to have 20-25% of all their money raised go to fees. So if they raise 100 million dollars, 20-25 million dollars just go to fees. I mean, it is just absurd and by the time the investors who put up the money and the risk get their return, it is peanut if anything. The third thing is, it is based on kind of on this return concept and that is the way they send out distribution is typically a portion of your principal and your interest.

[00:05:27] It is kind of like a mortgage, every time you pay off your mortgage, some of its principal, some of its interest and a lot of limited partnership backed in the same thing. They would send you this nice distribution but what you didn’t realize is that a good portion of that was principal and a very small portion was interest. It looked great tax-wise but fast forward to few years when they quit paying distributions and you haven’t even got all your money back, it can be really frustrating.

[00:06:00] now, I mean I just feel horrible for the situation that I was putting to sell those things. This is what financial planners are taught, this is the traditional method and back in the 80s and 90s, limited partnerships were a big part of the “diversification” and there were just tons of them out there and the problem is no one really did any study, did any kind of analysis as to whether or not this was going to be a good investment, it was just diversification. Anyway so district manager of mine, picked 4 or 5 limited partnership, I think there was cable in there, some oil and gas, some real estate and maybe some [00:06:51] then mutual funds, a little bit of bonds and this was supposedly this awesome portfolio that was going to carry these people the rest of their life.

[00:07:02] well, I don’t think they ever got any of their funds back from the limited partnership or I should say any return. There might have been one that actually return what they put in but most of them failed dramatically short of what they even put in. The mutual funds, I did okay but like all markets, they do well when the market are doing great and they really stink when the market are going down. The problem is there are still fees associated with those things. So those turned out to be somewhat horrible as well. The only thing that almost made any sense were the bonds and that was simply because interest rate was on the decline and interest rate move inversely with bond, so in market when interest rate go down, market value go up. So they actually did okay in the bond.

[00:07:59] I met with these people about every six months for years and years and then he finally passed away and then few years later, she did too and most of our conversation were built around what probably should have been done differently. And this district manager of mine ended up having all kinds of problems and anyway just very common unfortunately in traditional planning world to get so caught up in this diversification thing that they missed really the purpose of the investment in the first place and that is first to preserve capital, second to have a return on capital. Now, so why am I talking about this?

[00:08:46] I am talking about this for a couple of reasons, one is true diversification is really horrible and to think about it, the only way to be truly diversified is while something is going up in value, something has to be going down. Otherwise, you are not diversified. If everything is going up together, guess what, everything is going down together. This is what Buffet said diversification are for those who are ignorant and basically don’t really know what to do or how to do it and so they diversify. But then he goes on to say, every time you have something do well, you most likely going to have something that didn’t do so well and offset those gains. So you are just fighting against each other.

[00:09:32] Diversification basically fights one investment against each other and it is really hard to get anywhere if you are properly diversified. Here is the deal though, diversification in a lot of people’s mind is oh I have got some American funds, I have got some Fidelity funds, I have got some Vanguard funds and this is diversification when in reality that is not diversification. Again, diversification in the true sense is something needs to be going up while something is going down and who really wants to live with that kind of portfolio. But this is the battle that traditional financial face because if they don’t do asset allocation, if they don’t do diversification, they are going to have somebody looking over their shoulder saying why did you put their money here or here or here and you didn’t diversify.

[00:10:28] And this is even the problem in the CFP community. CFP stands for Certified Financial Planner, it is a test, it becomes a designation and a lot of these guys wear it proudly. And truthfully, it is not an easy course. I went through it, I actually dropped out in the last two because I was so frustrated that all they were really doing was essentially brainwashing me into the whole wall street jugging so that people would all warm and fuzzy because they were diversified but never really get anywhere. So I really don’t want to carry around that title or that designation and unfortunately they are very indoctrinated into this whole traditional financial planning thing and diversification, asset allocation, dollar cost averaging, all those buzz words that really don’t mean anything other than like I say they try to make you feel warm and fuzzy but that is not how to invest.

[00:11:33] And they go back to my podcast and video just a week or two ago where I talked about why in the world do our financial planners not trained in how Warren Buffet invests? You know he tells you that it is not that hard, he tells you that it is pretty easy to do but the problem is most people don’t take the time to learn it. Traditional financial planners aren’t on it, no one is trained in the whole Wall Street community on how to do this and it is really such a very simple concept and it is basically this: You wait to buy companies, great companies, companies you enjoy or one of the companies, you love them, you want to be a part of them. You wait for them to go on sale and when they go on sale, you go out and you buy 10 dollar bills for 5 dollars.

[00:12:27] I know that sound easy and it is somewhat easy but that is really the whole basis to what Warren Buffet, Monger, and [00:12:36] of those types of investors have been doing for decades. So more of this story and the reason for this podcast was to really talk about what diversification is, why it doesn’t work and why tradition financial planners use it. Maybe we didn’t really touch on that, the reason why they use it is because it is easy, it sounds good, it lets them just throw you know seed in the field and hopes something takes. Hopefully how to diversifying something is going to do well and it is going to look like they know what they are doing and have done the right thing by diversifying.

[00:13:20] And I don’t want to get too, I know sometimes I get too much on my soap box, diversification in some cases actually is probably what you should do if you don’t want to take the time to learn and understand. But when you diversify it might be best just to go into index. I am going to talk about indexes and how they work in the next podcast. You know Warren Buffet even told his family, when I die just take my money and put it in the index because overall he believes in the American economy, he believes America is going to continue to grow and the S and P index for instance is 500 of the strongest largest companies and over time it is probably going to do okay.

[00:14:08] he doesn’t want them diversifying, he doesn’t want them buying 50 different mutual funds, all he wants them to do is put the money in the index and ride with America. So for those who don’t want to learn how to invest, you don’t want to take advantage of the opportunities as they come along and just want to try to ride on the American co tails, then just probably going into index is the best thing to do. First of all, it is going to be much more less expensive in fees and cost and you do not need a financial adviser to get one.

[00:14:43] now with all that said, I want to just little disclaimer here, this is not a recommendation okay, I am not trying to encourage you to buy or sell or do anything in that effort at all. I just simply want you to understand what diversification, asset allocation, all those things really mean. I don’t even want you to go out and buy the index if that doesn’t make sense in your situation. So make sure that you are very comfortable, you understand the decision you are making and what that means to you in your financial life. Alright this might stir up some questions and I am excited for it, so if you have any question, feel free to reach out questions@wisemoneytools.com and I will try to answer them just as quick as I can and let’s see if we can get into a little battle royal just kidding with the traditional financial advisers so that they can tell us why diversification and asset allocation really do what and now that you know why, I and Warren Buffet thing it doesn’t work, let see what we come up with in our comment.

[00:15:50] alright, that is about it for this week, great to talk to you and again send your questions and your comments, even your snide remarks and if you ever want to have a strategy session and just talk? Let us know about that too and we will spend a few minutes with you on the webinar of some sort and we will talk about your particular situation and what you might be able to do a little better and until next time, I will talk to you later take care.

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