Okay, I'm shocked.
When I published an e-mail from a reader who has all of his family's money in Canadian bank stocks, I fully expected people to rip into him. I figured they would use words like "reckless," "risky" or even "nuts" to describe his investing strategy.
Nope. A few expressed concern, but many readers agreed with him. You can read the column, and their comments, online at tgam.ca/EGBW. Several readers also e-mailed me with similar sentiments.
Today I want to revisit this topic because I think the arguments in favour of an all-bank portfolio have some serious flaws that need to be aired. Let me reiterate: I own bank shares myself. They're hugely profitable enterprises that have generated hefty capital gains and churn out growing dividends. But they account for less than 20 per cent of my equity exposure and I would never allocate my entire portfolio to them.
Let's look at some of the arguments supporting an all-bank portfolio, and why investors should question them.
Banks supposedly generate the best returns.
True, banks have produced solid long-term gains, but a lot of other companies have done even better.
Royal Bank's total return – including reinvested dividends – of 289 per cent for the 10 years ended Sept. 30 was tops among the Big Five, according to Bloomberg, but it was just 53rd among members of the S&P/TSX composite index.
Among those that produced higher total returns were Telus (325 per cent), Canadian Real Estate Investment Trust (374 per cent) and Enbridge (457 per cent).
Still, nobody would consider putting all of their money into just one – or even all three – of these companies, so why go all-in on the banks?
Portfolio managers have to justify their existence.
Several readers suggested that portfolio managers recommend diversification because they'd otherwise be out of a job. This is nonsense.
Diversification has proven benefits for reducing risk. If an all-bank portfolio is really such a no-brainer, why don't insurance companies and pension funds fire all of their portfolio managers and put all of their money into bank stocks? Answer: Because it would be way too risky.
Canadian banks can't become insolvent or fail.
Do you think investors in 158-year-old Lehman Brothers thought the company could fail? What about 109-year-old Washington Mutual? Its 2008 collapse was the largest bank failure in U.S. history. During the financial crisis, scores of other U.S. and foreign financial institutions were taken over, nationalized or declared insolvent.
Yes, Canadian banks are strong and well regulated, but they are not bulletproof. Banks are by their very nature highly leveraged institutions, which is what makes them vulnerable when the value of their assets falls sharply.
The government will step in.
A large bank failure in Canada would be a destabilizing event, and let's hope it never happens. But a bank doesn't have to go under for equity holders to be wiped out or take a serious haircut.
As my colleague Tim Kiladze wrote recently (tgam.ca/EGC8), the risks for bank common shareholders could increase under new rules proposed by the federal government to make investors absorb losses before any public funds are put to work in a financial crisis.
In a recent paper, analyst Peter Routledge of National Bank Financial said the proposed recapitalization regime will "impact common shareholders more than any other bank stakeholder" and make "common equity valuation much more volatile during the most malignant phases of the credit cycle."
The banks will always have strong returns.
Mutual funds have been saying it for years: past performance is no guarantee of future returns. Just because banks have done well in the past doesn't mean they will continue putting up boffo returns. Something could change: a housing bust, a severe recession, a prolonged bear market, another credit crisis or something that nobody sees coming.
As a shareholder, I hope bank stocks keep generating solid returns, but I would never bet my entire portfolio on them. That's why I diversify with utilities, pipelines, telecoms, large consumer-oriented companies and other stocks that might hold up better during a crisis. For fixed-income exposure, I also devote a portion of my portfolio to guarantee investment certificates. I think of diversification as insurance. I might never need it, but that doesn't mean I shouldn't have it.