Diversification: why your portfolio needs it

There’s an old saying that goes, “Don’t put all of your eggs in one basket.”

“When it comes to investing, those are wise words to live by,” says Paul Moroz, a director and the deputy chief investment officer at Mawer Investment Management Ltd. “Diversification in a portfolio can protect an investor from market fluctuations and mitigate volatility.”

“If you were clairvoyant, there would be no need for diversification,” says Mr. Moroz. “You would just pick the one stock that was going to go up 100 times and that would make investing pretty easy. But the reality is, we don’t know how the world is going to unfold, and even if we think we have better odds, it might not work out that way.”

Gordon Pape, editor and publisher of the Internet Wealth Builder and The Income Investor newsletters, agrees that asset class diversification is an important part of building a portfolio. Study after study indicates that asset class allocation is one of the most important factors that determine the performance of any given portfolio. “In other words, it’s not so much what securities you select, it’s how you allocate them,” he says.

The first step when deciding on asset allocation is for investors to ask themselves, “What is it I want to achieve, and how much risk am I willing to take to achieve that?” says Mr. Pape.

Diversifying should start with the basic asset classes—cash, fixed income, and growth, says Mr. Pape. “If you’re a person who wants to limit your risk, then you’re going to lean more heavily toward fixed-income and cash securities because they don’t have the degree of volatility. And if you are a person who wants more growth and wants to take more risk, you would lean more toward growth securities.”

Another important way to diversify is by country and currency, says Mr. Moroz. “Governments can change, tax rates can change, currencies can fluctuate, banking systems can change, and so diversifying by country and currency can reduce market fluctuations in a portfolio due to things ‘zigging’ when other things are ‘zagging.’”

Mr. Moroz points out that Canadian investors tend to prefer Canadian mutual funds and stocks, but they should be looking beyond our borders. “It’s a home bias and it’s not just Canada; it’s prevalent in every country. People usually invest in what makes them the most comfortable,” he says. “It doesn’t have to do with logic; it’s the emotion of it. And that can be very difficult to break.”

Mr. Pape agrees that geographic diversification can offer big benefits, and he suggests that investors consider both U.S. and global products. “Many people don’t realize the tremendous imbalance in the Toronto Stock Exchange (TSX) toward financials and resources, and the real lack of other types of securities, such as information technology,” he says.

Diversification should also be achieved by varying the different industries in which you are investing, says Mr. Moroz. “A lot of times, you have technological change that impacts not only an entire business, but also a group of businesses—an industry—and that can change the profitability or business prospects,” he says.

It’s important to really look at whether you’re achieving true diversification, though, or if it’s just skin deep, says Mr. Moroz. He gives an example: “You own three stocks—a bank, a car dealership, and a company that owns real estate and leases it out. But, in reality, you find out that all three of these companies are based in Alberta. The bank lends to oil and gas companies, the car dealership is selling trucks to the oil and gas service industry, and the real estate company is leasing its properties in Fort McMurray. What you thought was diversification hasn’t given you any benefit because the portfolio wasn’t resilient, it wasn’t diversified by other factors,” he says.

Mr. Moroz suggests three rules to follow when determining asset allocation:

1) Never invest more than you’re prepared to lose. Don’t invest your kids’ education or house down payment in the stock market.

2) Don’t use leverage. Don’t borrow to diversify. If you’ve borrowed money to make a bet, then you’re negating the impact of the diversified portfolio.

3) The third rule applies to people investing in stocks. “If you’re investing in an equity portfolio or stocks, having three or five stocks doesn’t make you diversified. I think the number I see academically is north of 20 stocks. The stock-specific risks start to diminish, and you’re left with more of a portfolio risk. You can still diversify intelligently and try to be above average, but you don’t want to be in a situation where something goes wrong with one security, and it [all] falls apart.”

“That’s the benefit of investment professionals—providing that oversight and double-checking that not only is this portfolio diversified, but it’s also resilient. It can bounce back from different scenarios.”

Mr. Pape points out that diversifying by industry becomes a more sophisticated process that may be beyond the scope of some investors. “If you were to approach it in the classic way, it would mean identifying six to ten industry groups you want represented and choosing one top-of-the-line stock from each group,” he says. “Very few people can do that on their own.”

For investors who don’t have the knowledge or inclination to closely follow the market and juggle a portfolio of stocks, they can get basic diversification by buying a wide variety of stocks through a mutual fund or an ETF; “although, they are not all equal,” says Mr. Moroz. “Pick a broad mutual fund or broad ETF. Investing should be like watching paint dry—boring. Time goes by; you’re a little bit wealthier. That’s all it is.”