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The Most Common Portfolio Management Mistake

Diversification is one of the first portfolio management principles equity investors learn. It’s simple enough to understand; it’s simply an extrapolation of the old advice not to put all your eggs in one basket. And it’s good advice. But most investors have a narrow view of what diversification means.

Are You Making This Common Portfolio Management Mistake?

Protect Your Portfolio From Rising Rates

Warren Buffett Says …

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Are You Making This Common Portfolio Management Mistake?

Diversification is one of the first portfolio management principles equity investors learn. It’s simple enough to understand; it’s simply an extrapolation of the old advice not to put all your eggs in one basket. And it’s good advice.

But most investors have a narrow view of what diversification means.

For one thing, most investors focus on diversifying by industry. That means making sure investments from any one industry—finance, or consumer discretionary, or industrials—don’t make up too large a portion of their portfolio.

That’s a good rule, and one too many investors learned the hard way after betting everything plus the shirt off their back on technology stocks in the 2000 bubble.

Some investors diversify by asset class as well, owning some bonds, some stocks and some real estate or alternative investments. That’s a good idea too (although I have strong thoughts about anyone who owns bond funds today).

Diversification also usually includes quarterly or annual rebalancing to keep their best-performing assets from becoming too large a portion of their portfolio.

These are all good policies, but you can use diversification as a tool as well, to protect your portfolio from specific events or effects, or to limit your risk of loss.

To do this, you have to learn to think of diversification as more than a simple balancing of risk by sector. At its best, diversification limits your exposure to any type of broad market influence, whether it’s a downturn in a specific sector, rising interest rates, a foreign political crisis or a totally unforeseen event.

Protect Your Portfolio From Rising Rates

For example, right now, rising interest rates are on most investors’ minds. You may know that rising rates will be bad news for bond funds, which will be stuck holding low-yielding bonds that depreciate in value as newer, higher-yielding bonds become available.

You should also be aware of the effect rising rates could have on other segments of your portfolio. REITs (real estate investment trusts), utilities and other companies that carry a lot of debt will see their borrowing costs rise as interest rates climb. Preferred stocks will likely see some declines, and leveraged CEFs (closed-end funds) and other funds will have to adjust.

But there are several industries and asset classes that will benefit from rising rates, and diversification can mean making sure you have appropriate exposure to these investments in your portfolio as well.

For example, insurance companies become more profitable when rates rise, because they can earn higher returns on their investments and reserves. Two of the best-performing investments in my Cabot Dividend Investor portfolio over the past month have been boring old insurance companies.

My Diversification Recommendation

If you want to diversify by adding some positive interest rate correlation to your portfolio, an insurance company stock is a great way to do it. I can recommend Horace Mann Educators (HMN), the larger and more stable of the two insurance company holdings I mentioned above.

Added to the Dividend Investor portfolio in February, Horace Mann is an insurance company that serves school employees and their families. Founded in 1945 to provide car insurance to teachers, the company now sells auto, home and life insurance and annuities to teachers, administrators and other school employees. About 80% of customers work in K-12 public schools. The company has its own sales force of agents who maintain close relationships with the public schools in their districts.

About 34% of revenues come from auto insurance, 39% from annuity sales, 18% from property insurance and 9% from life insurance.

In recent quarters, earnings growth has been driven by strong sales of annuities and life insurance, as well as the introduction of new products like indexed annuities and other post-retirement products. Since 2009, operating income has increased at an average rate of 10% per year.

We’ve already enjoyed a 20% advance in HMN since I added the stock to our safe income portfolio in February. But the Fed’s rate hikes haven’t even been announced yet, so I think this is just the beginning of a very profitable period for Horace Mann and its investors. If you’re worried about the effect of rate hikes on your portfolio, adding some positive correlation can help offset any losses.

You can use diversification to hedge against other macro trends in the same way. The rising dollar is bad news for U.S.-based multinationals, but good news for international companies with significant U.S. sales, as well as domestic utilities. Rising consumer spending and lower unemployment have meant bad news for interest rate-sensitive investments recently, but are great news for consumer discretionary companies. A sufficiently diverse portfolio can balance the negative and positive effects of things you can’t control.

Warren Buffett Says...

On the other hand, there is such a thing as too much diversification. Warren Buffett has said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

Many investors take diversification to an extreme, investing only in broad index funds because they believe it’s impossible to beat the market. Others buy so many stocks that their portfolios begin to resemble index funds. But the more your portfolio starts to look like the broad market, the closer your returns will be to average. That’s fine if you’re happy matching the indexes, but not if you want to be above average.

In other words, even though diversification will help you limit risk by offsetting losing positions with winning positions, the opposite is also true—losses will offset gains and reduce returns.

If you know which way macro trends are going, weighting your portfolio toward the beneficiaries will generate better returns that balancing both sides. However, investors who were preparing for rising interest rates and rapid inflation in 2011 found themselves on the losing side of the trade for much longer than they anticipated. In fact, the difficulty of predicting the timing of major trends and macro conditions is the best argument for using diversification to offset exposure to things you can’t control, rather than trying to take advantage of them.

I hope you found this discussion helpful and invite you to forward it to any friends and family who might benefit.

Your guide to a secure retirement,

Chloe Lutts Jensen

Chief Analyst, Cabot Dividend Investor

P.S.

In my advisory, I present my favorite stocks in three tiers: high yield, dividend growth and safe income, along with all the tools you need to build a portfolio of income-producing stocks to diversity your portfolio in your retirement—or as you plan for your retirement. If that sound like something that can benefit your portfolio, click here to learn more.

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.