With global equity markets materially above their March lows and now trading relatively sideways, it’s a good time for investors to begin thinking about rebalancing and strategically repositioning their portfolios.
The first step in portfolio management is to reassess your investment objectives and risk tolerance, which may have changed with business closings, layoffs, pay reductions, and lower stock values.
The next step is to align your portfolio with your objectives and risk tolerance, coming up with a suitable asset allocation and security selection. These decisions will govern a portfolio’s performance, making it one of the most important stages in the portfolio management process. It is at this step when a key question arises – to diversify or not to diversify?
The benefits of diversification were introduced in the 1950s by Harry Markowitz and his Modern Portfolio Theory. This theory proposes that a portfolio’s volatility can be reduced by holding a variety of asset classes and owning stocks with low correlations and different sector exposures.
Investment professionals stress the importance of diversification. In fact, it is considered a fiduciary duty to diversify a client’s portfolio.
Many institutional investors who manage mutual funds and pension funds, for example, have internal and/or external, client-mandated risk controls that restrict a portfolio from deviating too far from a benchmark’s sector weightings.
Yet, this can create a problem, particularly when there are sectors with large benchmark weightings that have weak performance. For instance, the energy sector represents a large weighting in the S&P/TSX Composite Index and as such many institutional investors are forced to have an exposure to this sector. However, is this prudent and in a client’s best interest, particularly when a sector is underperforming?
Legendary investor Warren Buffett has openly rebuked the practice of diversification, saying, “We think diversification as practised generally makes very little sense for anyone who knows what they are doing. Diversification is a protection against ignorance.” He believes in owning a relatively small number of companies where an investor can maintain a comprehensive understanding of a company’s operations, the industry fundamentals, and its competition.
With differing perspectives on diversification, how should individual investors build their portfolios? Here’s my take.
First, make sure you have the appropriate mix of fixed income, equities, cash, and alternative assets such as real estate. This asset allocation should correspond to your individual investment objectives and risk tolerance. This will be a tailored asset allocation as each individual has a unique set of circumstances. For instance, let’s say an investor is 60 years old. I don’t believe you can say they must have a certain percentage in bonds without knowing their personal circumstances including their debt levels, income, expenses, risk tolerance, investment experience, investment horizon, and overall wealth.
Second, when it comes to your equities allocation, stick to a manageable number of companies in your portfolio. Be sure you have the time to actively stay abreast of each company’s financial report card, meaning its revenue growth, earnings growth, balance sheet strength, acquisitions, and the stock’s valuation. Take a lesson from Bay Street analysts who, on average, cover between 10 and 15 companies – and that is their full-time job!
If you have an investment adviser, don’t rely on this person to do your homework. Some may ask, “But isn’t this what you are paying an adviser to do?” An investment adviser may have hundreds of accounts to manage and may not attend to every single news release or conference call held by a management team. Furthermore, an adviser may rely on the firm’s analyst to decide what action to recommend. Analysts typically have “neutral” or “buy” recommendations but rarely slap a “sell” recommendation on a stock. An investment adviser may not see the need to contact an investor on a stock, particularly when there is no recommendation change by the firm’s analyst.
Take an active interest in your own stocks. Here’s a personal example. Many years ago, a stock that I was interested in was Mega Bloks Inc., before it was bought by Mattel Inc. On weekends, I would go to Toys "R" Us and look at Mega Bloks’ product selection, the product placement, the products of its direct competitor (Lego), the price points, examine what products consumers were interested in, and look at what products were out of stock. I would go to numerous toy stores throughout the quarter in order to get an idea about how the company’s upcoming quarterly earnings results may be. In my opinion, the person who will have the highest commitment to your money is you.
You need to have the time to review each company’s quarterly financial results, listen to every single conference call, read all of the company’s news releases, and stay informed on the industry and the company’s main competitors and how they are faring.
In terms of sector allocation, I recommend having a screen of criteria and then evaluate companies across all sectors to see how well they match these criteria – choosing the best-of-breed companies across an investment universe of stocks. I wouldn’t be focused on owning one gold stock, one utility stock, one consumer stock, one bank stock, etc. Now, each person will have different criteria depending on their investment objectives. For instance, a conservative, value investor seeking income may screen for companies that are large-cap, Canadian, have a history of annual dividend growth for the past decade, a payout ratio that is below 80 per cent, low leverage ratios, a favourable competitive landscape with high barriers to entry, and are trading below a certain multiple.
Here’s the bottom line
If you are a passive investor and do not have or want to spend the time and effort necessary to monitor your portfolio, then investing in a diversified exchange-traded fund may be the best investment approach.
If you are an active investor, willing and able to put in the time and effort necessary to manage your money, then I would take a balanced approach. A portfolio that is too diversified can limit its upside potential as gains will be diluted. While a portfolio that is too concentrated can present high downside risk. One or two “torpedo” stocks, those that rapidly drop in value, can wipe out all of a portfolio’s gains if the stock’s weighting is high. Keep in mind if your portfolio was valued at $100,000 and subsequently declines 50 per cent to $50,000, it must appreciate 100 per cent just to get back to where you started. A “Goldilocks” approach – that is, not too diversified and not too concentrated, may be the right investment strategy.
Jennifer Dowty has been an investment reporter at The Globe and Mail since 2015. Prior to joining The Globe, she worked for approximately 18 years in the financial industry, of which nearly 14 years were at Manulife Asset Management. During her time at Manulife, Jennifer was an equity portfolio manager responsible for managing institutional portfolios and mutual funds. Jennifer was awarded the Chartered Financial Analyst (CFA) charter in 2000 and received the Technical Journalist of the Year award in 2016 from the Canadian Society of Technical Analysts.
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Jennifer Dowty