Having a well-diversified portfolio means owning a wide variety of assets with the goal to reduce your overall portfolio risk. Having stocks in just a handful of companies would leave you open to the potential for substantial losses.
Stock diversification involves investing in a variety of economic market sectors, asset classes and locations. The idea is to smooth out risk by having the positive performance from some investments offset the negative performance of others. ie. avoid “putting all of your eggs in one basket”
For this to be successful, you need to hold assets that are not highly correlated: in other words, assets that won’t move in the same direction, at the same time, as each other.
Many Canadian investors believe they can achieve adequate stock diversification by simply buying an index mutual fund or index exchange-traded fund (ETF). These are effectively baskets of shares of many different companies that represent an index, such as the S&P/TSX Index (which contains around 250 of the 1,500-plus companies that are listed on the Toronto Stock Exchange).
Relying on an S&P/TSX Index fund is problematic, however. Two-thirds of the index is focused on just three sectors—financial services, energy and materials. Whenever there is a slowdown in global economic activity, energy and commodities tend to be negatively impacted. This in turn weighs down financial firms, which rely on those struggling resource companies for a large chunk of their business.
Given how these highly correlated sectors dominate the S&P/TSX Index, it’s difficult to offset losses by buying less-correlated Canadian sectors, such as health care, because they are so much smaller. Truly diversifying a stock portfolio for Canadian investors therefore requires looking beyond not only Canada’s borders, but also these dominant sectors and even traditional equities.
Moving your portfolio away from its natural “home bias” (where too many of the stocks are Canadian) is a good starting point for greater stock diversification. Here are some examples of other areas Canadians can consider, so that they have far more diversified portfolios:
• Geography: US, Europe, Asia, other developed economies, emerging markets
• Sectors: IT, Industrials, Consumer discretionary, health care, consumer staples, telecommunications
• Company size: Large cap and “mega” cap stocks (all Canadian stocks are considered small/medium size)
• Fixed Income Investments need diversification to: Government bonds, corporates, high-yield, investment grade, floating rate loans, etc.
One of the most efficient ways of diversifying a stock portfolio is through mutual funds and ETFs. For example, you could buy an emerging markets mutual fund, a U.S. large cap ETF and a global sustainable investing mutual fund. Each fund could contain dozens, or even hundreds, of companies.
There are now almost 1,200 ETFs and over 5,000 mutual funds available to Canadian investors. You can get far more specific about the geographical area you want to invest in, the sector and the size of companies you’re interested in.
Increasingly, financial experts are recommending an allocation to alternative investments when diversifying a stock portfolio. These were previously reserved for institutional investors but have recently become available to individual investors, in the form of liquid alternative funds and ETFs.
Many of these alternative investments have little to zero correlation with conventional equities and bonds, so they offer a great way of diversifying a stock portfolio. Some alternative funds include:
• Real estate investment trusts (pools of properties that deliver rental income)
• Alternative strategies, such as leveraging, using derivatives and short-selling
• Private equity (investing in companies not listed on stock exchanges)
• Private debt (lending to privately owned companies)
Year-to-year and day-to-day, markets do go up and down. That roller-coaster ride of volatility can make some investors want to shy away from participating in the markets. However, there is room for even the most risk-averse investors to benefit from the markets.
Holding equities in well-diversified portfolios is essential if you want to grow your portfolio more quickly and investing in low-volatility equity products can also help to smooth out the ride.
Low-volatility equity funds are appealing if you want returns that are similar to the stock market but with potentially greater stability through market ups and downs. These funds can reduce losses during market dips, which can in turn help to preserve your assets and contribute to your retirement income stream now and in the future.
We’ve seen how truly diversifying a portfolio is particularly important in Canada – especially when so many Canadians have much of their wealth already tied to the domestic economy in their real estate. However, achieving effective diversification is not as simple as buying an emerging markets mutual fund and an S&P 500 Index ETF; it’s not easy to build truly diversified portfolios by yourself. This is where a professional advisor comes in.
A qualified advisor will take into account your risk preference, personal circumstances and financial goals before recommending the right mix of equities, bonds, industries, geographical locations, company sizes and alternative assets and strategies that will build a truly diversified portfolio.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.