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A wealth of selection at the diversification buffet

Some say diversification is one of the only free lunches in investing. That's not entirely true, but I would certainly consider it to be a super cheap buffet. The problem is that many people just stick to one end of the trough.

Let me explain. While we certainly understand the perils of putting all your eggs in one basket, I think that many people are not extending the concept fully. Sure, we know that holding only one stock could lead to riches or ruin. You could lose it all, or your portfolio could double in value within a few weeks. By holding one thousand stocks and bonds in equal dollar amounts in a diversified portfolio, we expect that some go up, some go down, and some stagnate over various periods of time. We trade the chance at making a killing for the certainty of never getting killed. And even that is not without the occasional body blow.

But why stop there? Why stop at only holding Canadian stocks, as many investors do?

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For non-registered portfolios, the dividend tax credit makes Canadian equities more attractive once you consider the after-tax returns vis à vis similar holdings domiciled in other markets. Foreign-listed investments are also further subject to currency fluctuations. And of course, there is the comfort factor. We have a better time sticking to our guns when we drive by the companies we invest in on a regular basis.

On the flip-side, however, it's worth noting that the TSX is dominated by three sectors: energy, materials and financials. It's not the epitome of a diversified economy, but we've been OK with that because it's worked in our favour for the last few decades compared to other economies.

The benefits of multi-level diversification are worth examining if you can stray out of your current comfort zone. Multi-level diversification can consider the following:

  • Equities vs. fixed income
  • Geography - domestic vs. foreign developed vs. foreign emerging markets
  • Small cap vs. mid cap vs. large cap
  • Active management vs. passive management
  • Private equity
  • Direct real estate investments
  • Value vs. growth

Each of these asset classes or investment styles tends to have its own cycles. The winner over any short time period is a crapshoot, and no one can reliably pick the next top dog. Sometimes emerging markets are on a tear even though domestic equities and fixed income are in the doldrums, and sometimes it's the complete opposite.

With an investment policy statement that includes a clear rebalancing protocol, you can reduce the volatility in your portfolio by incorporating investments from the other end of the buffet trough.

Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More

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