Is Your Portfolio Truly Diverse?
Many of us understand that we are supposed to have diversity in our portfolios. After all, portfolio diversity is one of the basic tenets of successful long-term investing.
However, diversity goes beyond just having stocks and bonds in your portfolio. There are other measures of diversity as well. Here are some things to keep in mind as you build a diverse portfolio.
The first thing that comes to mind when thinking of portfolio diversity is often asset class. These are broad categories of assets, including cash, stocks, bonds, real estate, commodities, currencies, and other classifications.
At its most basic, your portfolio should include different asset classes. Some of these asset classes move inversely to each other, so you might be able to protect your portfolio when asset class is struggling.
While you don’t need to include every asset class in your portfolio, make sure that your investments are dominated by just one class.
Your investments can be further divided into sectors and industries. This is especially true of stocks. Many portfolio management experts frown on having all of your stocks in one sector or industry.
If you have everything in service-related companies, but that industry tanks, you could be in trouble. Try not to be heavily invested in one area. Mix it up with financials, services, miners, energy, and other sectors and industries. When you look at your mutual funds and ETFs, make sure that you aren’t overlapping too much with your holdings.
This is also important in other areas, too. Don’t put all of your currency investments in developing countries; add in some established economies.
Don’t limit your real estate investments to residential, include commercial. Think about how you are diversified on levels a little more specialized than asset class.
Many people overlook geographic diversity when putting together a portfolio. However, this might not be the best idea. If you aren’t comfortable investing in individual bonds or buying rental properties in other countries, there are funds that can allow you to get access to stocks, bonds, real estate, and currencies on a global basis.
Looking beyond your borders can be a good idea. You can put a small portion of your portfolio in assets from developing economies. At the very least, consider looking to the south for investing opportunities. There are a number of attractive stock investing opportunities in the United States, including dividend plays that can benefit your portfolio.
How Your House Effects Diversification
Borrowing from your home equity is a popular way to invest. By using a Smith Manoeuvre, you can accelerate your investments and pay off your mortgage sooner.
However, when looking to add further diversification to your portfolio, avoid using your Home Equity Line Of Credit (HELOC) to invest in Real Estate Investment Trusts (REIT) since they are so closely correlated. If the real estate market were to collapse, not only would your investments in REITs go with it, but the value would drop on the house that’s backing the loan.
How Your Career Effects Diversification
Some of the best corporations offer employees stock purchase plans at a lower cost than can be obtained by the average investor. Sounds like a good idea? It is, though you may do best to sell at the end of the year and reallocate that money to other stocks.
Why is this? One example comes to mind, Nortel. If you worked for Nortel and received stocks as an employee, once the company fell apart not only were your without a job but your investments were devastated at the same time.
This same portfolio theory applies not just to the company you work for, but also the sector you work in. For example, if you work at a travel agency, investing in Air Canada or WestJet would leave you exposed to greater risk if travel is reduced due to changes in the economy, increased security or epidemic concerns.
Portfolio diversity isn’t just about asset classes. There are other ways to add the protection of diversity to your investments and to improve your overall performance. As you build your more diverse portfolio, though, make sure that you are careful to take into account your risk tolerance.
If you can’t handle the volatility that often marks the commodities market, don’t add commodities to your portfolio just to have them. If you do include them, don’t make them a large part of your portfolio. You want to make sure that your portfolio reflects your needs and your risk tolerance as well as being appropriately diverse.
Nice post. You should consider all assets when you are reviewing your investment portfolio.
I am trying to be diverse. I have directed my work pension to the fund that is the most conservative, my RRSP mutual fund at my bank is a medium risk that is mainly North American with some international exposure and I hold individual stocks, one that I picked on a whim, in my TFSA.
I am dealing with a lot of debt so each of those 3 investment vehicles each has less than $3,000 in it. I am pleased with how my money is allocated I just need heaps more of it.
Unless there is some incentive to using an RRSP (such as a company matching contribution or if you are in an exceptionally high tax bracket 46%+) are you sure you should put your money in an RRSP at all right now? If you will have a low income in retirement, it’s usually best to max out a TFSA before starting to contribute to an RRSP. However, there may be other reasons why an RRSP makes sense for you. (Could also be a locked in one from a different job, etc. etc.)
Remember, we all had to start. So you’re doing well because you have started. That’s the hardest and most important step. It gets better!
The problem with diversifying away from stocks is that you may reduce volatility, but you’ll also reduce returns. Diversification by sector makes a lot more sense if you’re actually trying to grow your capital while smoothing out increases and decreases. In the end, every asset has risks; with enough time, the returns on stocks tend to outrun everything else.
CDB re: “The problem with diversifying away from stocks is that you may reduce volatility, but you’ll also reduce returns.”
This is wholly untrue.
Research Harry Browne’s ‘Permanent Portfolio’, among others.
Thanks for writing the articles I don’t have time to write, Tom. There is so much information out there, but very little perspective, and I find your posts address a lot of the basic issues I see over & over again.
Typo alert: In your first paragraph, pretty sure you meant to say: “make sure that your investments are NOT dominated by just one class.”
You can/should also diversify via ‘return drivers’.
Great article! Diversification is a huge factor of risk and return. Especially as index funds and ETFs gain popularity it is important to look at the individual assets you have contributed to!
Diversification and asset allocation should take into consideration whether you are actively investing (i.e. the accumulation years) versus living off your portfolio (i.e. the depletion years).
As another commenter said, growth is seen with equity and then you can diversify within equity for another level of risk management.