Whenever you visit your financial advisor – or open up just about any book on investing worth its salt, for that matter – you’ll probably find yourself being reminded about the importance of diversification.
When it comes to investing, diversification can mean a lot of different things. It can mean diversifying your portfolio related to the number of positions you hold – owning 1,000 stocks, for example, instead of just 10. It can mean diversifying by sector, like making sure you own stocks that are spread out over a number of different sectors, such as resources, finance, consumer stocks, technology and industrial.
Diversification can also mean diversifying your holdings by country or region. I generally recommend that my clients allocate a third of their portfolios to Canadian stocks, a third to the U.S. and a third to non-North American equities.
The theory behind diversification is that’s safer than putting all of your eggs into one basket. If the price of oil falls by 25 per cent tomorrow, for instance, your portfolio would take a much bigger hit if all you own is shares in Exxon. There’s also another theory, which says you don’t get paid for risks that can be diversified away. What this means is, if you invest all your cash in one stock, sector or region, not only will you be taking on a much greater level of risk; it’s also statistically unlikely that – over time – you’ll do any better than someone who holds a broadly diversified portfolio.
If you’re an investor, the whole reason you buy stocks is to get a premium over the returns you could get from bonds or GICs. That return is referred to as the risk premium. Stocks are all about risk. That’s why they bring such high rewards.
Since I started in this business 30 years ago, the markets have gone up by between 7 to 13 times (depending on which market you’re looking at). The only real risk that comes with investing in stocks is volatility. Stock markets may go up, and they may come down. But over the long-term, they’re all-but certain to end up higher eventually.
Unfortunately, this isn’t necessarily true for investors who aren’t sufficiently diversified. Need an example? Just ask the holders of Enron or Nortel when they think those stocks will be coming back. To put it another way, individual companies go out of business all the time. Stock markets do not.
Being diversified is the safest and most reliable way to harvest the premium return that stocks can offer, while minimizing the risk associated with it. But despite that fact, many investors (and even many financial advisors) continue to insist that diversification isn’t a winning strategy.
Why? Well, for one thing, diversification doesn’t always look very sensible. Consider the technology bubble of the late 1990s.
Before the burst in 2000, most people agreed that it seemed foolish to buy anything other than tech stocks. With the benefit of hindsight, we all know now what a bad idea that was. But for people who were swept up in the rush, that bad idea looked awfully good for an awfully long time.
It also doesn’t help that looking backwards to see what’s “working” in your portfolio (and what isn’t) almost always points to a move away from diversification. In 2011, oil was over $140 a barrel, the Canadian dollar was at a premium compared to its U.S. counterpart, and U.S. banks looked like the poor cousins of Canada’s banking juggernauts.
As a result, we had record flows of international dollars into the Canadian stock market. Canadian investors likewise dumped their U.S. and International holdings in favour of Canadian equities, because we were all so sure that resources were the place to be, peak oil would keep prices skyrocketing forever, the future was never going to be brighter – blah, blah, blah.
In other words, investors were betting that what did so well yesterday, was going to keep on delivering the biggest bang for their buck tomorrow. So what happened?
In fact, 2011 turned out to be a turning point for U.S. and Canadian equities. Since then, U.S. markets and the U.S. dollar have surged, while the Canadian markets and currency have plunged. So naturally, money is now pouring out of Canada and into the U.S – because after all, cheap oil will mean a soaring U.S. economy, the greenback will continue to surge, and the U.S. housing market is well on its way to recovery. So surely the good times are here forever, right?
My point is not to dissuade you from investing in the U.S., any more than it is to encourage you to try to figure out where oil is going to go in the next quarter, or what the GDP of China will look like in three years. My bottom line is simply that diversified investors did just fine through all the various shocks of the last 30 years. And they’ll do just fine through all the ups and downs of the next 30 years.
If you ask me, that sounds like a pretty good way to fund a retirement plan.
Alan MacDonald an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates. Past performance is not indicative of future results.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.