Diversification

There are two primary investment strategies that every investor must master and every approach includes – Asset Allocation and Diversification. We describe Asset Allocation here, but in brief, the goal of Asset Allocation is to create a portfolio with Assets that reflects the characteristics of the investor at that time in their investing life.  The characteristics are defined in terms of age, risk tolerance, and other key factors that Financial Advisors use to construct portfolios that reflect the typical risk profile of an investor with those characteristics.

 

Diversification is another key concept in investing.  The objective is to limit the variability in the returns of the portfolio by creating a large basket of different assets.  In that way, while the individual assets might have variable returns, when taken as a whole, the entire portfolio has predictable return.

 

The concept is best illustrated by an example.  Let’s assume that 3 friends (Don, Mary, Bill) got together on January 1, 2015 and decided to save toward a once in a lifetime trip that they would start on January 1, 2018.  They would all invest $10,000 on January 1, 2015 and sell their investments on December 31, 2017 (hold for 3 years).  To make our example simpler, let’s also assume that they only could choose between the following Canadian stocks in their portfolio:

 

Bank of Montreal (BMO)

Barrick Gold Corporation (ABX)

BlackBerry Limited (BB)

Canadian Pacific Railway (CP)

Dollarama Inc (DOL)

Hudson’s Bay Company (HBC)

Maple Leaf Foods (MFI)

SNC-Lavalin Group (SNC)

Telus (T)

WestJet Airlines (WJA)

 

Don didn’t understand the principles of diversification, so he took the entire $10,000 and bought shares of Westjet, since a friend told him the stock was going to go up.

 

Mary also didn’t have much investing experience but chose 4 of the 10 stocks, the ones that were discussed on a local investing program that week.

 

Bank of Montreal (BMO)

Canadian Pacific Railway (CP)

Maple Leaf Foods (MFI)

SNC-Lavalin Group (SNC)

 

Bill’s friend was a Financial Advisor, so he learned that the best strategy would be to allocate his money to a variety of stocks so he bought $1,000 of each of the 10 stocks.

 

The returns at the end of the 3 years were as follows for each of the stocks (Dividends invested).

 

Bank of Montreal (BMO)                   11.22%

Barrick Gold Corporation (ABX)      13.18%

BlackBerry Limited (BB)                     3.30%

Canadian Pacific Railway (CP)           2.08%

Dollarama Inc (DOL)                          39.09%

Hudson’s Bay Company (HBC)        -21.95%

Maple Leaf Foods (MFI)                   23.75%

SNC-Lavalin Group (SNC)                11.01%

Telus (T)                                               8.84%

WestJet Airlines (WJA)                       -5.11%

 

 

Therefore, the returns for each of the friends were as follows.

 

Don     -5.11%

Mary   12.02%

Bill         8.98%

 

So, just looking at the results, you might say that Mary had the best strategy as she had the best return of the three. But Mary was lucky – she hit one of the strongest performers (MFI) and missed the two stocks that had negative returns (HBC and WJA). But what if Mary had put Westjet in her portfolio (like Don) instead of Bank of Montreal?  Then, she would have had a worse return (7.93%) than Bill.  And if she would have picked Hudson’s Bay Company instead, her returns would have been almost wiped out.

 

The point of this little example is that the more assets you hold in a portfolio, the more consistent your return will be with fewer fluctuations and surprising outcomes. Bill had both of the negative return stocks in his portfolio but he still saw a reasonable return because he had the two stocks that had strong returns as well.  There will be fewer positive surprises, but there will be fewer negative surprises too and investors have been shown to favor consistent returns.

 

Diversification is not only in the number of assets in the portfolio but in the type of assets you hold as well.  A strong portfolio is diversified in terms of number of assets, types of assets (stocks, bonds, cash), geography (Canada, US, Europe, Asia), types of equity (dividend versus capital appreciation, large versus small companies), maturity of bonds and a number of other factors.

 

Creating a diversified portfolio can be done through careful research into the different asset classes and acquisition of the different types of assets, keeping in mind Asset Allocation principles as well.  Mutual funds and ETFs are a simple way to create diversification although they come with a price in terms of fees.  But for people with substantial assets, the best way to create a well-diversified portfolio with an appropriate Asset Allocation is to contact a Financial Advisor as this is one of the primary services provided to investors.  Connect with a Financial Advisor here.

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©2020 BY SMART INVESTING FOR CANADIANS

All articles herein are presented as an educational resource and should not be considered as professional financial or individualized investment advice. Readers should always exercise their own judgement when making any decisions about their money.

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