What is diversification? In simple terms diversification means not placing all of your eggs in one basket. When designing an investment portfolio the main goal is to achieve your required average annual rate of return while at the same time minimizing the level of risk and the volatility in the value of your accumulated savings.
One of the accepted methods to minimize your investment portfolio’s level of risk and volatility is to invest your savings in more than one asset category and more than one or two individual investments within those asset categories.
When discussing portfolio diversification, it can very much be like peeling an onion where there can be more than one layer of diversification applied to your portfolio. But in general, there are basic layers of diversification:
- Diversification between asset categories
- Diversification within each asset category – (Cash and Cash Equivalents, Fixed Income and Growth)
- Diversifying Cash and Cash Equivalent investments
- Diversifying Fixed Income investments
- Diversifying Growth investments
As we discussed in our Introduction to Portfolio Design, when investing there are so many variables that are unknowable. This means no one knows what the future holds, not even the experts know what the future holds. What are a few of the things that investors have no way of knowing?
- Where will interest rates be next month, next year, or next decade? Are interest rates going to be higher or lower?
- What asset categories will out perform next month, next year, or next decade? Will real estate outperform or will it be gold, stocks or bonds?
- What asset categories will perform horribly next month, next year, or next decade? Will bonds do poorly or maybe it will be real estate and stocks?
- What business industry or sector will outperform next month, next year, or next decade? Will mining and oil stocks outperform or will it be utilities, pipelines and communications?
- Which foreign economy will outperform next month, next year, or next decade? Is China the best place to invest or maybe it is India or Europe?
- Which stock market will outperform next month, next year, or next decade? Will the stock market move higher from here or are we at a new top?
- Which mutual fund, exchange traded fund or stock will outperform next month, next year, or next decade?
So your chosen investment approach and the design of your portfolio should try to defend your savings against unknowable future events. Your portfolio design should accept that the future will not always unfold as you expect and it should be flexible enough to enable you to make modifications as circumstances dictate.
By investing your accumulated savings in more than one asset category and individual investment, you can help to defend against losses to your savings that result from unknowable future events.
Diversification between asset categories
As we discussed in Step 7: Determine your Asset Allocation, asset allocation is a method of allocating your accumulated savings to investments within three basic categories: Cash and Cash Equivalents, Fixed Income, and Growth.
Each category has minimal connection to the other two and, as a result, their investment returns and market values typically do not move in the same direction at the same time. If the market for one category is down the other two categories may not be. In other words, when stock market values are down, Fixed Income values will remain the same or may be up and Cash/Cash Equivalent market values will remain unchanged. By using the different asset categories within a designed portfolio, you are able to reduce the volatility in the market value of your investment portfolio through good and bad market cycles.
Note: This benefit is supported by the data published by Russell Investments and summarized in our Step 7b: Single Asset vs. Multi-Asset Portfolios.
Example: According to Russell Investments, if you had invested your savings, between 1976 and 2006, in a portfolio consisting of 100% stocks, your average annualized returns would have been 13.2% with an annualized standard deviation or volatility of 12.9%. If on the other hand you had allocated your savings 35% to stocks and 65% to bonds you would have had an average annualized return of 11.4% with an annualized standard deviation or volatility of 7.0%. Therefore, by adopting an allocation to stocks and bonds you would have earned an investment return that was 13.6% lower, but your portfolio’s value would have been 45.7% less volatile.
By investing your savings in different asset categories, you are able to defend the value of your savings against future unknown negative events and minimize your portfolio’s volatility, while only giving up a minimal difference in investment returns. No single asset category will be able to satisfy all of your investment goals, all of the time. Consider the following:
- Investing a portion of your savings in Cash and Cash Equivalents can provide stability and liquidity that can be perfect for the cash reserve you may need on short notice.
- Investing in Fixed Income investments can provide your portfolio with a steady, reliable and predictable income stream and their stability is a nice counter-balance the price volatility of inherent in Growth assets. Fixed Income investments are like a foundation for your portfolio.
- Investing in Growth investments can provide an income stream and offer you the greatest promise for future price appreciation.
Remember: Balancing the positive and negative characteristics of each asset category within the context of your financial goals, current financial circumstances, and investing personality is the goal of portfolio design.
Diversification within each asset category
For most investors, diversifying their savings within each particular asset category is often one of the most challenging steps in the investing process. This is often the case due to the abundance of differing investment advice, theories and marketing literature issued by the investment industry.
Diversifying within an asset category can be as complicated or as simple as you want to make it. If you have a high interest and an abundance of time to allocate to your investments, then you can properly manage a more complicated set of diversification guidelines.
Example: If you feel you need to have a portion of your investment portfolio invested in the emerging economies (Brazil, Russia, India and China), and you have the time and interest, then you can incorporate investing in individual emerging economy companies into your diversification guidelines. If you do not have as much time or interest, then you can take a short-cut and buy a mutual fund or Exchange Traded Fund (ETF) that invests in emerging economies. These already have established their own guidelines for screening and diversifying their investments.
Or an even simpler and cost effective approach is to invest in a well-established, successful multi-national corporation that invests and operates businesses within the emerging economies. These companies have typically been investing and operating within the emerging economies for decades. Let them search out the winning business opportunities using their investment and diversification guidelines. This is simpler because you let the multi-national corporation deal with the language, cultural, business, currency, accounting and government differences that can make investing in foreign economies extremely complicated for a Canadian investor.
As with any task that seems overwhelming, begin with baby steps. Divide the larger task into smaller, more manageable tasks. First establish diversification guidelines for each individual asset category. Design guidelines that compliment your time and interest and begin with the simplest category (Cash and Cash Equivalents) and work your way to the more complicated (Growth).
Begin planning your diversification for each asset category by defining a few basic guidelines, namely ask yourself the following:
- What dollar amount is to be invested in the asset category?
- What sectors of the asset category do you want to invest?
- How many individual investments do you want or need to own within the asset category?
- What is the minimum asset quality or credit rating you are willing to own?
- Within the context of your overall investment portfolio, does each individual investment have a specific, identifiable job?
- Are you investing equal dollar amounts in each individual investment?
- If you are not going to invest equal dollar amounts, how will you determine the amount to be allocated to each individual investment?
Diversifying Cash and Cash Equivalent investments
Typically, by maintaining a portion of your savings in Cash or Cash Equivalents the intent is to provide you with liquidity for future short-term needs or to provide a parking place for savings that are intended for longer-term investments in another asset category.
Remember: Each individual investment can be assigned a specific job description, therefore, providing liquidity and safety as the primary jobs for investments in this asset category.
The selected investments should maintain a high credit rating, provide easy access to your capital and provide you with a small income. Some of the potential investment options include:
- Cash balance in an account
- Units of a money market, T-Bill mutual fund
- Banker’s Acceptances
- Discount bonds with a maturity date less than 12 months
- Regular bonds purchased at par or a discount with a maturity date less than 12 months
Note: Typically, Banker’s Acceptances, discount bonds and regular bonds can be sold prior to their maturity dates. The price you receive will depend upon the investment’s credit quality, liquidity and the current interest rate environment.
There is no optimum number of individual investments to hold for this asset category. If you are going to use more than one investment, you can select investments that mature close to the time that you require access to the monies.
Diversifying Fixed Income investments
Savings allocated to Fixed Income investments are to provide the portfolio with a strong foundation with a high degree of safety and a regular reliable investment income stream. If Growth investments are to be used within the portfolio, investments in this category are to help balance the price fluctuations of Growth investments. When allocating savings to this category, you should define your guidelines prior to searching for specific individual investment options.
Typically, your guidelines for diversifying Fixed Income investments should include some or all of the following:
- Quality Minimums: What is the lowest credit quality you are willing to hold? This guideline becomes even more important for Fixed Income investments the longer their maturity dates. This is because the future financial health of the issuer is unknowable five, ten, or fifteen years from now. You may be comfortable holding investments rated “BBB” if their maturity date is within the next year or two, but may want a minimum credit rating of “A” or higher for investments with a maturity date longer than two years.
- Maturity Dates: How long do you want your savings invested for? Do you want to keep your Fixed Income maturity dates to five years or less? Do you want some Fixed Income investments to mature in fifteen or twenty years?
- What type of issuers are you happy to invest in? Do you only want investments that come with a government guarantee – Guaranteed Investment Certificates (GIC), Government Bonds? Are you comfortable with owning corporate bonds?
- What type of Fixed Income investments are you going to own (bonds, GICs, preferred shares)?
- How many individual Fixed Income investments are you going to own?
- What is your desired income payment frequency? Do you want monthly, quarterly, semi-annual, annual or compound income payments?
Note: There is no optimum number of individual Fixed Income investments to own. You should keep in mind the monies invested in Fixed Income investments are to be sheltered from risk and to provide you with reliable, regular income. As a result, you should try to maximize the income generated, while maintaining a comfortable credit quality and a maturity schedule that fits with your investment views. And you should own a number of Fixed Income investments that have different maturity dates. This would allow a portion of your Fixed Income monies to mature and be reinvested on a regular cycle.
Example: If you are going to invest $25,000 of your portfolio in Fixed Income assets, you might consider dividing this amount into five equal amounts of $5,000 each. You can then invest each so that you have a portion maturing each year for five years. If you did this, then your maturity schedule would look like the following:
One of the unknowable influences when investing in Fixed Income is the future direction of interest rates. For over 30 years, the investment industry has been saying that interest rates are going to rise and for every year they continue to decline. Thus, trying to guess the future direction of interest rates is pretty much a futile activity. You are better to select a maturity time-frame that you are comfortable with and simply, mechanically reinvest maturing monies to maintain the structure of your selected maturity schedule.
Example: When the $5,000 Fixed Income investment matures in 2012, you are often better to just mechanically reinvest the proceeds in another fixed income investment that matures in 2017 no matter what the offered interest rate might be. This allows you to maintain the same maturity schedule and it eliminates the guesswork that would be required to anticipate future interest rates.
Diversifying Growth investments
Setting guidelines for Growth investments can be as simple or as complicated as you desire. Setting diversification guidelines for Growth investments are important because savings invested within this category do not have guarantees on the return of your capital. Monies invested for price appreciation are also exposed to price depreciation and diversification is one of the two main methods to reduce the risk of losses to your savings.
The two most widely accepted methods of reducing pricing risk from Growth investments are through diversification and hedging.
- Diversification is the best-understood and most common method to reduce the risk of investment losses.
- Hedging your Growth investments against the risk of investment losses is a more complicated strategy and is not covered in our discussion.
Note: While both of these strategies can help to reduce the risk of investment losses, they cannot eliminate the risk.
Diversifying your Growth investments can be simple or complicated and it may include some or all of these forms:
- Diversify by industry or sector. You can decide to allocate a portion of your Growth assets into any number of sectors (for example, the Banking and Financial, Oil and Gas, Pipelines, Industrial, Consumer, Communications, Technology, Mining, Precious Metals, Forestry, Utilities or Health Care sectors).
- Diversify by the market size of the issuer. (For example, you could focus on large or small-capitalized companies, junior companies, exploration companies, etc.)
- Diversify by business cycles. Do you want to invest in cyclical industries or are you more interested in non-cyclical industries?
- Diversify by valuation category. Do you prefer to own investments in Growth oriented or Utility type companies? Do you prefer to make Value oriented investments or are you happy to pay the market price for a Growth oriented company? Do you invest only in companies that pay high dividends? Are you looking for the next Microsoft, Apple or Facebook?
- Diversify by geography. Are you only comfortable with Canadian Growth investments? Are you interested in investments in emerging economies or staying with developed economies?
- Diversify by currency. Do you want all of your investments dominated in Canadian dollars? Do you want exposure to other currencies – U.S.$, Euros, British Pounds, etc.?
- Diversify for your investment style and investing personality. Are you an active trader or do you want an investment that you do not need to look at everyday? Are you a risk-taker or are you risk averse?
Note: Diversification into above areas can be important because, just as with asset categories, individual Growth investments do not all enjoy the same investment cycles. For example, if shares in the Banking and Financial sector are rising, shares in the Oil and Gas sector may be declining in price.
Each individual Growth investment should have a specific job within the portfolio. So, for example, if you own common shares in BCE Inc., then BCE has a job within the portfolio. Its job description might define its job as to first provide reliable, regular investment income through dividend payments. Second is to provide your portfolio with an opportunity to benefit from share price appreciation that results from growth in the communications and broadcasting sectors.
Once you have allocated a portion of your investment portfolio to Growth assets, you will need to decide how many individual Growth investments to hold.
More often than not, it is very difficult to find 50 great investment opportunities. From experience, we do know that if you were asked to name 10 companies that would make a great investment, you would probably be able to name them fairly quickly. If we asked you for another 10 companies, you might be able to name them, but we bet you would struggle. If we asked you for another 10, now up to 30 holdings, we bet you would be unable to name them. In fact, we bet that if you could name an additional 10 names, you would simply be pulling names out of a hat and you really would not know if they were a good investment or not.
In addition, the number of investments you chose to diversify your portfolio must be manageable. If you are making your own investment decisions then select a number that is manageable. Owning 10 or 12 core companies in different sectors and complimenting these with one or two Exchange Traded Funds (ETFs) or mutual funds should be more than sufficient to provide you with a well diversified portfolio of Growth assets.
You are often better served by owning a small group of well-researched investments that you understand, have confidence in, and know are manageable.
Remember: In summary, by diversifying your portfolio amongst the different asset categories and within each category you can reduce volatility of your portfolio’s market value, while at the same time maximizing your investments returns.
There is a substantial amount of academic work that has been done in determining the optimum number of Growth investments to hold.
Remember: The primary reason for diversifying is to minimize the volatility in the market value of your portfolio.
Studies on diversification with Growth investments
A number of studies have looked at answering the following question: “How many individual Growth investments should an investor own to maximize their investment rate of return, while minimizing the pricing volatility of the portfolio?” The answer to this question will vary with the type of Growth investments you choose to own. Are your Growth investments going to consist of mutual funds, ETFs, or the common shares of individual companies? Here are a few people of note who have tried to answer this question:
- In 1977, E.J. Elton and M.J. Gruber in their book Risk Reduction and Portfolio Size: An Analytic Solution, examined the decrease in a portfolio’s volatility for numerous sets of individual investments in common shares. Their work established that the majority of the benefit from diversification was attained once an investment portfolio held 30 individual stocks. Above 30 individual stocks the additional benefit from diversification was minimal.
- Some academics and writers such as Burton Malkiel in his book A Random Walk Down Wall Street, suggest that a portfolio that holds between 12 and 30 individual stocks will eliminate the majority of pricing risk from a portfolio.
- According to the Canadian Securities Institute, (Wealth Management Techniques, 2004, pp9-12 to 9-16), approximately 90% of the maximum benefit of diversification can be achieved with a portfolio of 16 to 20 stocks.
- The optimum number of individual stocks to own will also be dependant upon the types of companies you are purchasing. If you are buying shares in small, junior or exploration companies, the optimum number of individual investments will be considerably higher.
- For mutual funds, the optimum number depends on who is publishing the study and the suggested number of mutual funds to hold ranges from 7 to 30.
- According to Morningstar in Chicago, after seven mutual funds the diversification benefit from adding additional mutual fund positions is negligible. They also found the number of mutual funds you own is less important than how diverse those mutual fund holdings are. Owning seven “large-growth” mutual funds won’t diversify your portfolio the same way as owning one “large-blend,” one “small-value” and one “small-growth” fund would.
- We do know that the average mutual fund holds, on average, 172 individual investments. So owning seven mutual funds may imply that you own interests in 688 companies or more, not accounting for duplications.
You may find that no single asset category can achieve your financial goals, but each can make an important contribution, and a well-designed portfolio can help to coordinate your investment decisions.
Now you are ready for Step 9: Develop a written Investment Policy Statement (IPS)