Sooner or later, any investor building a portfolio is bound to ask: do I have the right mix?
Answering is not necessarily easy. It’s hard to tell if a portfolio is overheated with a few stocks, or spread too thin with a multitude that doesn’t necessarily make good investment sense.
There are different ways to achieve a balance according to standard, tried-and-true principles. One way is called asset allocation, another is diversification.
Although they may sound like the same thing, there are many shades of differences between the two.
“Diversification is the technique of spreading your portfolio across a number of different investment types, in order to reduce your overall risk,” says Darren Coleman, senior vice-president and portfolio manager at Coleman Wealth, Raymond James Ltd. in Toronto.
There’s a simple underlying wisdom behind the technique, he says: “Don’t put all your eggs in one basket.”
“Asset allocation is a form of diversification. It refers specifically to the amount of one’s total accumulated savings that are invested in the various asset types,” says George Christison, British Columbia-based financial adviser and founder of the investingforme.ca website.
“When it comes to asset allocation and diversification, it should never be a question of one or the other. The two are complementary and necessary in a well-designed and managed investment portfolio,” Mr. Christison says.
An investor who allocates assets might divide a portfolio according to different asset types, he explains. For example, a portion of the portfolio can be put into liquid assets – cash, money-market mutual funds, short-term bonds and treasury bills, all of which can be cashed in quickly if you need the money in a hurry.
“Another portion might be put into growth assets – publicly traded common shares, mutual funds, exchange-traded funds (ETFs), real-estate investment trusts (REITs) commodities and options,” Mr. Christison says.
A third allocation might be to fixed-income assets – bonds and debentures, preferred shares, guaranteed investment certificates (GICs), mortgages, mortgage-backed securities and so on.
Investors should also keep in mind that real estate can make up another allocation – your house, cottage or condo.
Still hard to see the difference between asset allocation and diversification? Think of it this way, says Mr. Coleman: “Diversification can be much more creative.
“We’re talking about spreading risk, and that can be done in a large number of ways. Some examples of how we can diversify are by company size, by industry, by geography, by investment style [value or growth] or by currency,” he says.
At the same time, investors should be careful to make sure they are actually diversifying, if that’s the goal.
“We sometimes see people adding in different investments to diversify a portfolio, without recognizing that they are very similar,” Mr. Coleman says.
“For example, if you own TD Bank and Royal Bank stock, then do you really reduce risk by adding in CIBC or BMO? Only marginally. A better fit may be to add in a U.S. bank. Or maybe an agricultural company or an e-commerce business. Look toward something that is also a great business, but in a very different [sector] than the banks.”
Both diversification and asset allocation are important for investors managing their portfolios in these turbulent times, says Sandra Foster, Toronto-based financial author and president of Headspring Consulting Inc.
“The stocks of one industry could all be affected by the public statement of one person or one event,” she says. For example a politician speaking for or against a pipeline could affect a wide array of energy and energy-related stocks.
“It is less likely that stocks across all industries would be affected by the same statement or event. You can diversity within each asset class,” Ms. Foster says.
Mr. Christison agrees, saying that, “Discussing portfolio diversification can be like peeling an onion, where there can be more than one layer of diversification applied to your portfolio. In general, there are basic layers of diversification, though.”
In addition to those listed by Mr. Coleman (company size, industry, geography, investment style and currency), Mr. Christison adds the category of business cycles – do you want to invest in a sector that is prone to cyclical ups and downs or one that is steady?
Investors should also look carefully at their own personalities for clues as to how much diversification they seek.
“Ask yourself: are you an active trader or do you want an investment that you do not need to look at every day? Are you a risk-taker or are you risk averse?” he says.
The reason that both asset allocation and diversification are important is because, “No one has a crystal ball to tell them the future,” Mr. Christison adds.
“No one knows which asset type is going to outperform and which will underperform. No one knows with absolute certainty which sector of the economy will outperform and which will underperform.” One need simply look at the predictions from half a decade ago that oil will reach $200 a barrel and supplies will run out in a few years.
Similarly, “No one knows which country will outperform and which will underperform. Is Canada going to be the next top dog or will it be the United States?” Mr. Christison says. It’s also hard to determine whether active or passive trading will do better at various times.
“A well-allocated and diversified portfolio can help to defend against our ignorance about future investing outcomes.”Report Typo/Error
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