July 20, 2009, 5:00 am

6 Investing Rules Revisited Part 3: Diversification allows reducing portfolio risk

by: The Financial Blogger    Category: Financial Cliché,Investment, Market and Risk
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candiesI remember my finance classes where our teacher was hitting our brains with a bunch of theories explaining why diversification was the only way to insure an optimal yield while reducing the volatility (called risk by the common investor) of a portfolio. There was tons of big brain that became famous in the finance world providing investing strategies based on diversification. This is also the main reason why we have so many mutual funds and why they are so popular. Everybody is selling them 😉

The point of being well diversified still stand. However, we are not as protected against a drop in the market as we thought we were. The point was to invest in several industries among several geographic markets. Therefore, if the oil industry in Canada was stalling, you could always hope that the manufacturing industry in China would perform or that the big blue chips from the USA would consolidate their position and grow stronger.

Unfortunately, in 2008, there were no escapes. While the S&P 500 were losing 38% of its value, the Brazilian stock market dropped 40% and the Chinese companies fell by 51%. This is a surprising consequence of having a global economy: each country is linked to others and influences their global economy. It’s like 50 kids in a daycare: if one gets the flu, the daycare is half empty by the end of the week!

The only survivors from 2008 were the money market and government bonds… Not much to keep investors happy about their “well diversified” portfolio! They look at their statements and they only think about calling their financial advisor and ask about investing in several countries in order to reduce their risk…

Diversification allows reducing portfolio risk, revisited:

Being diversified will optimize your investment return and reduce the volatility of your portfolio. However, this does not mean that it will save you from important market crashes. There are several ways to be diversified:

Economic sectors (financials, materials, techno, health, etc.). Having all your money invested in a few economic sectors makes your vulnerable to them… Just think about financials and resources in 2008 or the techno’s back in 2000.

Countries (USA, Canada, International). Even though all economies are linked to each other, you are better off not taking the chance of not picking the right country. Worst comes to worst, you will still benefit from the markets come back.

Asset classes (stocks, bonds, commodities, real estate). Then again, if you are invested solely in real estate, you might miss great opportunities on the stock market and vice versa.

However, I do not believe in being diversified by:

Financial institutions (this only duplicates your investment statements and makes it difficult to follow).

Mutual fund companies (you may be able to find a good mutual fund company and stick with them. You will probably save more money on fees with a bigger amount).

Financial advisors (you are better off with only one financial advisor as he can see the full picture and give you proper advices. What if he doesn’t know that you have 30% in the US market elsewhere and suggests US investment products since you don’t have any in your portfolio with him?).

Mutual funds (by selecting more than one fund doing the same thing you automatically select one with higher MER’s than the others and therefore, pay more for nothing.)

Those methods are more related to “diworsification” than diversification 😉

The key point to remember is diversification reduces the risk but does not make it disappear.

image source: flickr.com

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It’s true that stock market diversification didn’t work too well (although some signs point to that simultaneous movement being a temporary effect), but diviersifying between stocks and (safe) bonds would have helped so there is always some protection to be had. It’s safe to say that the idea of creating a portfolio of stocks that’s as reliable as a bond is dead though 🙂

In some cases it might also make sense to diversify by financial institution if you’re at risk of the bank going under and not getting your investments back, by advisor if they would be able to run off with your money (of course it will be a few years before they can think of this again), or by mutual funds if you want protection against a manager becoming out of touch with the market (since there are probably under 10 actively managed funds in north america that would interest me this would be hard to diversify)..

I think the distinction between diversifiable and nondiversifiable risk is one of the most useful ones in the entire investment industry. No need to take on any risk that won’t be compensated with an increase in expected returns. Might as well go ahead and diversify as broadly as possible within each asset class that you decide to own. 🙂