What constitutes good diversification?
Often, we see a high number of stocks in the portfolios of do-it-yourself investors. The result is then an excessive concentration in equities and in only a few sectors. However, this type of allocation is likely to lead to a much higher level of risk for a portfolio that is supposed to be diversified. When stock markets become chaotic, these investors could be the first ones affected by major losses, as the only asset class found in their portfolio is equities.
In reality, proper diversification means having exposure to multiple asset classes. In addition to Canadian and global equities, you can consider assets with little or no correlation with stock markets, including:
- Real estate holdings
- Precious metals
- Alternative assets
Properly balancing your portfolio using various asset classes can ensure more linear long-term returns, thereby reducing extreme fluctuations. The current market climate—with a rising trend for close to 10 years—should lead you to opt for caution. The time may be right to make sure that your diversification is sound and consistent.
What should you invest in to diversify your portfolio?
When incorporating multiple asset classes into a portfolio, it is also important not to over-diversify. For example, a Canadian bond fund will hold a multitude of corporate and government issues and a single fund could very well suffice to cover your bond universe. In terms of real estate, there are a wide range of real estate funds that allow you to access companies that manage real estate portfolios. If the Canadian real estate market appears too expensive or too limited to you, global real estate funds can also be an option. Once again, a single fund is enough to cover this universe.
Another appealing asset class is alternative assets. These lesser-known assets are likely to generate comparable returns to equities in the long term, but with a correlation that differs from stock markets, resulting in an additional measure of diversification. Incorporating them into your portfolio will reduce your overall risk without necessarily reducing returns. Alternative assets include structured products, private debt funds and mortgage funds. As a general rule, these types of assets are less liquid and despite their importance in a well-diversified portfolio, you’ll want to limit exposure to them to a maximum of around 20% of its composition.
In summary, diversifying a portfolio does not necessarily mean you reduce its returns. The long-term experience of well-diversified investors is normally more favourable since they will substantially reduce their risk without necessarily reducing returns. Unfortunately, for some, the quest for high returns at any cost will expose them to too much volatility when markets panic. However, the negative emotion related to the investment process could raise doubts in investors’ minds. This is often when they try to “fix” things, which exposes them to an additional risk of making mistakes in doing so. Emotion is never a good guide for investing.
We need to remember that by building a diversified portfolio, we can be sure to lessen variances in the returns that financial markets have in store for us, including risk, without necessarily hindering future returns.
Jean-Philippe Bernard is an advisor with National Bank Financial. National Bank Financial is an indirect wholly owned subsidiary of National Bank of Canada. National Bank of Canada is a public company listed on the Toronto Stock Exchange (NA: TSX). The opinions expressed herein do not necessarily reflect those of National Bank Financial. The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The securities and sectors mentioned in this document are not suitable for all types of investors and should not be considered as recommendations. Please contact your Investment Advisor to find out if a security or sector is suitable for you and to obtain more information, including the main risk factors.
Edited on 15 June 2018