What is diversification?

A prospective client recently proposed that an alternative to hiring a professional portfolio manager might be simply to put all his funds in to Canadian banks stocks. We responded that such a portfolio would be, in our view, under-diversified and could expose him to risk.

diversification

What is diversification and how much to you need?

Over the past 20 years, Canadian bank stocks have rewarded patient investors with good dividend income, growth in that dividend income and capital gains. The bulk of that growth is simply due to economic growth in Canada; some is due to good management. Part of it is due to the fact that as interest rates have fallen from historic highs in the 1980’s to historic lows today, Canadians have be seduced into taking on more and more debt, allowing banks to expand their assets and boost their earnings. Read more here>>

Over the next 10 years, there is a risk that Canadians will likely reduce their debt levels, as happened in the US after the 2008 credit crisis. The trigger could be higher interest rates, a recession, or some external shock. We are not suggesting Canadian banks would fail under such a scenario, but they would likely see reduced earnings, which could potentially lead to dividend cuts and declining stock prices.

So, what is diversification and how much to you need?

We believe that maintaining a well-diversified portfolio of 25 to 30 stocks will yield a cost-effective level of risk reduction. Investing in more securities may yield some further diversification benefits, albeit at a drastically smaller rate.

Our view is that the stocks you hold should also be spread across a number of sectors of the economy. So as well as financial companies, investors should also hold some utilities, some industrial companies, some consumer goods business and have some exposure to the resources sector. Depending on your risk tolerance, you may also want to diversify across other asset classes, such as bonds and real estate.

Sector diversification works because as the economy goes through a business cycle, factors that adversely affect one sector can benefit others. Consider a period of rising inflation: rising material prices can reduce the earnings of industrial and consumer businesses because they may find it difficult to pass increasing costs on to their customers. But rising material prices tend to boost the earnings of resource companies. So stock price gains in one sector tend offset declines in another.

(It is worth noting that external shocks, such as the 2008 credit crisis, can cause all sectors to decline simultaneously. On the plus side, quality stocks tended to maintain their dividends and recovered faster, reflecting the value of the underlying businesses.)

Today, Canadian investment advisors typically do not hold individual stocks in their clients’ accounts. They generally put their clients into mutual funds and ETFs.  In our view, the problems with both mutual funds and ETFs are 1) that they tend to hold many stocks, 2) many funds in Canada tend to track the S&P/TSX Composite Index, leaving investors over-exposed to the resource and financial sectors, 3) many funds are highly concentrated in a particular sector, and 4) funds contain embedded fees that are invisible to clients. Advisors often compound over-diversified by holding a large number funds in their clients’ accounts. We have seen accounts with over 20 funds! If your advisor still has you in mutual funds, this post will help you understand the difference between mutual funds and portfolio management.

Advisors also use “individually managed accounts” or “separately managed accounts” which give clients the illusion that they own securities directly when in fact they are participating in a managed pooled fund.

We believe that investors are better served by following our three-part value investing strategy. In our view it is the best way to reduce risk and volatility and earn consistent returns over time. Our diligent, patient and opportunistic approach has served our clients well, through good and bad markets:

  • Appraise the intrinsic value of each company over a business cycle;
  • Seek long-term growth of capital by investing in companies that we perceive to be mispriced;
  • Utilize a margin of safety to promote return of capital…not just return on capital.

Why does our value investing approach work? The prices of well-established, high-quality stocks tend to rise over time as the companies create value for shareholders.

The benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Having a manager who has a fiduciary duty to act in your best interest;
  • Transparency—no hidden fees or commissions;
  • Competitive cost.

What is Successful Investing? Learn more here>>

Download Our Free Special Report – How to Hunt For Value Stocks. Michael Sprung will share with you 5 stocks set for long-term gains here>>

We believe clients are more concerned about losing money than making speculative gains. Like to learn more? Please contact us here>>

The opinions expressed here are ours alone. They are provided for information purposes only and are not tailored to the needs of any particular individual or company, are not an endorsement, recommendation, or sponsorship of any entity or security, and do not constitute investment advice. We strongly recommend that you seek advice from a qualified investment advisor before making any investment decision.

 

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