There's true portfolio diversification, and then there's fake diversification.
In this era of low interest rates, be especially wary of the fake kind. That's where you swap out bonds in favour of income-producing investments, like preferred shares or dividend-paying common shares. Substitutions like this are rationalized on the basis that bonds pay only trace amounts of interest right now and are basically dead money.
I was reminded of this faulty reasoning by a query from a reader close to retirement whose adviser had gone with a mix of 60 per cent stocks and 40 per cent fixed income. "The fixed income is in preferred shares, not bonds," this reader wrote. "Is this a good strategy?"
It is, if all you're after is yield. Preferred shares offer yields in the 4 to 5 per cent zone, while a five-year Government of Canada bond yields about 1 per cent and five-year guaranteed investment certificates get you not much more than 2 per cent at best.
But for true diversification, those preferred shares are a letdown waiting to happen. Traditionally classified as a "widows and orphans" type of investment, preferred shares are actually quite twitchy. They're sensitive to changes in interest rates – both up and down moves. Also, you can't count on preferred shares in a market meltdown. In 2008-09, preferreds were hammered while bonds soared.
For the five years to April 21, the S&P/TSX preferred share index posted a cumulative loss of 18.2 per cent. The index is coming off a nice little 12-month gain of 13 per cent, but you can clearly see that prefs can be a handful for extended periods.
Use bonds or GICs to balance your stocks, not more stocks. This applies to preferred shares, and to the dividend-paying common shares investors have loaded up on in recent years thanks to strong total returns based on dividends and share price growth. Bonds may seem like dead money now, but that's OK. When the stock markets tank, those bonds will rise from the dead. You can't expect that from preferred shares.