Proper Portfolio Diversification
Once upon a time a topiary artist invested all his money in shears and hedge funds. But he lost all of it because he wasn’t properly diversified. We diversify our assets so if one investment fails miserably it won’t drag down the rest of our portfolio with it. Owning 10 stocks is better than 1. But there comes a point when adding more stocks to a portfolio ceases to make a measurable benefit. Many experts suggest that optimal diversification is achieved when an investor holds 15 to 20 stocks spread across various sectors of the economy. 🙂
So if our portfolio contains 100 different stocks in 10 different industries then we are properly diversified right? Hold the mayo. I would argue no. Although we have a wide range of stocks and sectors, we really only have one asset class – stocks. Common stocks represent equity in publicly traded companies. But if a business becomes insolvent then its equity could be completely wiped out. This is why we have other asset classes such as bonds, which gives investors some recourse in a liquidation situation.
Okay, so diversification means having a balanced portfolio of index funds with both stocks and bonds right? Well, not quite. The capital markets can be highly volatile and it operates on a system that isn’t always reliable. In 1914 the US stock market shut down for 4 straight months. More recently in 2001 the NYSE was offline again for several days. This means at any time investors could be locked out of the market without warning. So other than financial assets, we can also invest in hard assets such as real estate, private businesses, gold, or other commodities. Over the past 2 decades Canada has gradually lowered interest rates and loosened borrowing rules, which encouraged consumer borrowing. This made the cost of living more expensive, especially in larger cities. But those who bought homes in Toronto circa 1996 and kept it until now would have seen their home prices rise to keep up with, or even surpass the inflation rate.
Alright, so if we buy stocks, bonds, real estate, and everything in between, then we are properly diversified right? Well, almost. We still have all our investments in one currency, and in one country. Purchasing a global fund that tracks the performance of stock markets around the world can help, but most investors would buy them in their local currencies, which may not be enough.
No nation is immune to currency collapse. Venezuela was once considered a rich country not long ago. But things quickly changed when the price of oil fell 50%. This year the consumer price inflation in Venezuela is set to hit 480%. And according to the International Monetary Fund, the inflation rate is projected to top 1,600% in 2017. Around 31 million people live in the country and there is a huge shortage of food. Over the past weekend over 35,000 Venezuelans visited the neighboring country Colombia to buy food and medicine. That’s taking cross border shopping to a whole new level. ? An investor in the Venezuelan stock market could see his portfolio double or even triple in price over the year! But due to runaway inflation he would actually be poorer because the value of his currency will have lost more than 90% of its value. So diversifying away from one’s domestic country is highly recommended.
It appears the proper way to truly diversify our investment portfolio isn’t very straight forward. But if we keep all these things in mind, we can do a better job of spreading out our risk and making wiser financial choices. 😀 Although it doesn’t guarantee against loss, diversification can certainly help us reach our financial goals while minimizing risk.
__________________________________
Random Useless Fact:
Hey Liquid, another great post as usual.
Sometimes we like to complain about inflation eating away at our investment returns. Thinking about Venezuela provides some valuable perspective!
Thanks. I hope we never see inflation like that in Canada. But I’ll continue to hold onto my gold coins just in case. 😉
Well said. Too many investors these days simply buy a bunch of stocks across various sectors without really paying attention to market caps, asset classes, geography etc. Achieving diversification across is pretty hard to do and requires a lot of management from the investor.
R2R
Some people who make large down payments on their home and have a small company matching RRSP plan think they are well diversified, when in fact 90% of their net worth is in real estate.
Great points, that many of us fail to think about when we are establishing our portfolios. I have the bulk of my portfolio now across 5 mutual funds to achieve the global, international, equity and bond, differing type of stock, attributes that you mention. I also really diversified into real estate through rental properties…in three different markets, thankfully! Good post, cheers,
Good stuff. Sounds like you’re quite diversified.
Lots of food for thought. By your definition, I’m certainly not diversified! I own real estate and stocks. Some mutual funds that have a small portion invested in bonds. Some mutual funds that invest in international stocks. But no gold. Mmm… maybe I should buy me some!
I treat gold the same way as other asset classes. I don’t try to time the bottom or the top. I continue to buy small amounts occasionally when I have extra savings to spare. I’m glad it’s risen 25% this year so far, but it will probably continue to strengthen if government bonds stay at their low negative interest rates around parts of the world.
You can’t talk about diversification without talking about concentration. The biggest financial decision most (all?) people take is choice of career/vocation — ultimately a decision to be highly concentrated in one company/sector. Take a look at Alberta to see how this can affect both the individual but also the general economy. The source (and amount) of income will affect all other financial decisions which follow. As stated, “diversification can certainly help us reach our financial goals while minimizing risk”. Diversification is used to keep money; concentration is used to expand money. Take a look at Alberta to see how this can affect both the individual but also the general economy. Anyone who was in Alberta during the Boom times saw a tremendous amount of (easy) benefit (and witnessed a complete circus); anyone who was in Alberta during the Bust received a concentrated punch to the gut. If you look at any of the world’s wealthiest Capitalists, all of them will have their money in concentrated positions — this is how they became wealthy. “The way to become rich is to put all your eggs in one basket and then watch that basket”, said Andrew Carnegie, who built the world’s first… Read more »
All your points are spot on. Venezuela is an example of a failed socialist experiment which is totally political in nature. They nationalized more than 1,200 companies, landholdings and corporate assets. No wonder the country went into a crisis lol.
I was going to suggest Gold/Silver was not such a bad investment from the perspective of a Venezuelan. As long as it’s stored safely and you can get to it without someone shooting you in the street going to get a few coins. I see you beat me to it. There is so much metal bashing out there. The arguments against are so thin. I recently came across another form of holding gold which the concept seems pretty interesting. If you Google “Goldmoney” you will see what I mean. I have been toying with the idea of starting a small account and seeing how it works. Basically you buy gold, fund an account and get a linked MasterCard which deducts your gold and changes it into money which pays for your purchases. (I would try to buy in on dips) Where this concept seems to shine is when you shop across borders as there no unexpected high exchange loss anymore. If your in the US it uses the spot price in US. If you are in Canada, its Canada’s spot price. Apparently this works in many countries. I would really like to hear from a regular person on if they… Read more »
“There is so much metal bashing out there. The arguments against are so thin.”
Do the arguments ‘for’ have more weight?
I invest to make money… I care little of diversification to be honest. If you stay focused on the prize, long-term prosperity, diversification will naturally become present. What gets you where you want to be, expert or Jack of all and master of none? I would argue Ive met both at the top… chose the path that works best for who you are and your situation. – Cheers
It’s good to know that both specialists and generalists can make it to the top. The only factor that seems to be consistent is focus and hard work.
[…] asset class in the world, investors have had little reason to condemn it. Anyone who holds a diversified basket of securities should have done very well recently. For example, my net worth so far this year has increased by […]
[…] The first and second rules are straightforward. Billionaire Jeff Bezos recommends we think in 7 year terms to remain competitive. I suggest taking that up to 10 years just to be safe. 🙂 In terms of diversification it can be mean more than just having stocks and bonds. […]