What is diversification?
For our purposes, diversification means lowering the overall risk in our investment portfolios by owning a wide variety of assets.
Here’s the rationale for this: significantly different assets will likely respond differently to the same event (i.e., they aren’t highly correlated). This means that some assets will change in value differently compared to others (or even change in the opposite direction) in response to a market event. Owning some assets of each kind mitigates some of the risk in your portfolio (i.e., it lets you sleep better at night ) while still allowing for reasonable growth (i.e., it lets you retire at some point… if you want to).
What are the ways of diversifying?
For stock and bond investing, some of the major ways you can diversify are:
- Among different companies within an industry
- Among different industries within a country
- Among different countries, as correlations in different economies may be low
- By holding both stocks and bonds, which are generally negatively correlated (i.e., they generally move in opposite directions)
Additionally, you likely should diversify into completely different asset classes as well, like:
- Cash and cash equivalents
- Commodities (e.g., gold, copper, beef, crude oil, natural gas, etc.)
- Real estate
My absolute fav is Canadian real estate. I’ve been a real estate investor for several years now, owning long-term buy-and-hold residential properties as well as investments in new developments and second mortgage lending. In general, the risk-reward relationship seen with stocks & bonds gets somewhat thrown out the window when you invest in real estate because, with real estate, you are in much greater control of the outcome. There’s a reason why the vast majority of the richest people in the world made their fortunes in dirt. It does take more work than the others, though. I talk more about this in another post.
What are the downsides to diversification?
- Diversification limits the upside growth potential of your portfolio since some of the assets you hold won’t grow as much as others. (Wouldn’t it be nice to know which ones ahead of time?)
- Risk can never be eliminated completely and well-diversified portfolios can still lose money sometimes
- Becoming more diversified can cost you more time and money (because of the incremental costs associated with buying more individual assets). This is likely the reason that mutual funds have become so popular – they allow you to pay for a single asset that contains a diversified basket of individual stocks & bonds. Caveat Emptor: not all mutual funds are created equal. We’ll revisit this in another post.
What do the pros think of diversification?
Well, the vast majority of people out there believe that a well-diversified portfolio is definitely the way to go. I certainly agree with them in principle. Where I may found myself at odds with them, though, is when it comes to the notion of asset allocation. Please see my post on this for more.
For a contrarian view about diversification, we need look no further than The Oracle of Omaha:
“Put all of your eggs in one basket and then watch that basket very, very closely.” – Warren Buffet
While I respect the heck out of Warren Buffet and what he’s been able to accomplish in his life (not to mention his ethics and penchant for giving back to his fellow humans), his statement presupposes one very important caveat: that the person watching the basket has the ability to affect the outcome of the eggs it contains.
The fact of the matter is that with many of the assets we choose to include in our investment portfolios, we don’t have that option. For example, when we invest in the stock market, we have the ability only to choose what we invest in and when we choose to make those investments. Once we’ve done so, the only choice that’s left to us is whether to buy or sell – we can’t influence the stock price (and therefore our profit or losses) at all. Once we buy a portfolio of stocks and/or bonds, then we are at the mercy of “the market” for determining our outcomes. Over time, the stock market trends upward. Unfortunately, though,
“Every once in a while, the market does something so stupid it takes your breath away.” – Jim Cramer
There are no sure bets in the world of investing; there is risk in everything. You have to be prepared for the ups and downs.
So when does diversification make sense?
Most of us don’t have the kind of time (or the motivation) it would take to watch the eggs in our baskets closely enough. In other words, we tend to invest in assets over which we have no real control.
So, to put it simply, for Canadian MDs, diversification ALWAYS makes sense.
Action Steps (10 minutes total)
- Make a list of your investment portfolio assets
- Evaluate whether, overall, you are diversified in terms of asset classes, companies, industries, and countries
- Figure out which of these, if any, is missing
- Read my posts on the missing ones to determine how best to add them to your investment portfolio
What do you think about diversification in investing for Canadian MDs?
Please add your two cents below.
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