Investment basic Number Two is to diversify your savings and investments, what we colloquially mean when we say “Don’t put all your eggs in one basket”.
Putting your entire fortune into one penny mining stock, that your brother-in-law promised was a sure thing, is the opposite of diversification. Keeping five bucks to invest in a Lotto Max ticket would be a degree of diversification. Because both are high risk and most unlikely to pay off, you might say the (poor) odds are correlated and that is the opposite of diversification. But go ahead and buy that lottery ticket. Just remember it is from your consumption budget for the fantasy thrills it gives you and not from your investing budget.
The investing principle of diversification means choosing investments whose returns are not correlated, which do not simply move up and down together, driven by similar forces. This begins with the first principle of Balance in selecting your mix of fixed income or equity assets. The returns may both be driven by the relative strength of the overall economy but returns on fixed income assets will not go up or down as much as equity assets may in an uncertain economy.
Different economic activities, and the companies pursuing them, are classified in sectors. You balance your investments amongst sectors with non-correlated volatilities, so that, for example, when financials go down, consumables go up.
Diversification is also based on geography. Canada did relatively well in the 2008 crisis (didn’t lose as much as others). But the TSX does not provide a diversified portfolio. The relatively small Canadian market is dominated by Financials (34.7%), Energy (25.2%) and Materials (12.9%). So not only is diversification limited across sectors but their trend behaviour tends to be correlated, they all go up and down in sync so there is little compensation between them. In the 14,000 businesses in the MSCI World index, only 20.1% are Financials, 9.6% are Energy companies and 5.8% are in the materials sector. If you stuck to a Canadian TSX ETF for your diversification, you would be missing out on Consumer Discretionary at 12.3%, Information Technologies at 11.7%, Industrials at 11.3%, Healthcare at 11.2% and Consumer Staples at 10.1%.
U.S. equities are a much larger pond that is more widely diversified across sectors. We may be motivated by patriotism to invest in Canadian small cap funds, but as much or more of your portfolio should be in U.S. equities. Then there is the rest of the world to consider. Europe may not have fared as well as North America in the 2008 crash but it is still a very large and diverse market, recovering nicely (despite Brexit) in 2017. There are large economies in the BRIC countries (Brazil, Russia, Indonesia & China), and “emerging markets” like South Africa. There is a trade-off between higher growth rates and more volatility over the short to medium term, but these markets still deserve some consideration in your portfolio.
In THE End OF WORK, I use the Canada Pension Plan Investment Board as an example of a well-balanced portfolio, about 50:50 fixed income versus equity investments. It is also well diversified in order to provide more consistent, less volatile returns.
Diversity is applied by the CPPIB geographically by only having 31% invested in Canadian assets while 69% is invested globally. The proportions are even more dramatic in its equities portfolio where only 5.4% of its assets are invested in Canadian equities while 40.6% are in foreign developed markets. So if you are feeling unpatriotic about putting some of your RRSP in a U.S. large cap fund, don’t feel guilty. Money is global. If you want to feel patriotic, go to a Jets game and yell “TRUE NORTH” during the anthem.
And the CPPIB has its equity investments well diversified across economic sectors as well. Even the CPPIB’s fixed asset portfolio is diversified with 19.4% of assets in bonds and money market securities while it has 13.2% in real estate, and its infrastructure investments have reached 7.6% of its assets (toll highways and bridges are great cash flow generators).
Diversification can even include a mix of risk. In choosing your asset allocation, I had recommended against gambling, but maybe a little is OK. Even CPPIB has 6.3% of its assets in equities in emerging markets. Yes, they may be more volatile, but they are expected to give higher returns. Just like you might use permanent insurance (for estate and tax reasons) at the conservative end of your portfolio, six or seven cents on the dollar at the high volatility end is not too much gambling.
Seeking diversification can be a major focus for do-it-yourself financial planners, but for those who really do “Have Better Things to Do”, keep the other 80% of your retirement savings in balanced funds, similar to the 50/50 mix found in the CPP. You might also achieve your mix in different funds that are treated differently for tax purpose. But that is Step 6 in November. We still need to tell you about the third key to investing, dollar-cost-averaging, in October. Keep reading your Smart BIZ!
Fredrick Petrie, B. Comm. (Hons.), author of “THE END OF WORK: financial planning for people with better things to do”, provides financial education at www.navigatingfinance.com, reach him at firstname.lastname@example.org or call (204) 298-2900. You can get started at http://www.amazon.ca/END-WORK-Financial-Planning-People-ebook/dp/B00XCY0AJ2/