What is True Diversification?

In last weeks blog post we talked about a technical concept called “Upside/Downside capture” (If you haven’t read that yet click here). In order for a portfolio to have good upside and downside capture, there needs to be proper diversification.

What is diversification?

Diversification is a way of systematically spreading your investment assets around so you don’t “have all your eggs in one basket”.

It is surprisingly common for people to think that their investment portfolio is diversified because it’s split up between two or more advisors, institutions, or investment products. Just because someone works with two investment advisors doesn’t mean those two advisors aren’t providing the exact same underlying investment recommendation.

With that being the case, how does someone obtain real diversification? That is the question that we are hoping to answer.

Correlation

One important term in understanding diversification is correlation. Correlation is a statistical measure that determines how assets move in relation to each other. It can be used for individual securities, like stocks, or it can measure how asset classes or broad markets move in relation to each other. It is measured on a scale of -1 to +1.

If we have two things that move in the same direction at the same time, they have a positive correlation. Since we are close to Halloween, a good example of positive correlation would be sales of candy and pumpkins. The consumption of both increase during the lead up to Halloween and decline back to base levels for the rest of the year.

On the other hand, if two things move in the opposite direction at the same time, they have a negative correlation.

When looking at an investment scenario, a positive correlation is extremely good during a bull market. However, when a bear market hits, a positive correlation can be detrimental to the portfolio’s performance.

If a portfolio has a +1 correlation related to the market (or index), it would have an upside capture of 100% and a downside capture of 100%. Meaning that the portfolio is participating in all the market gains and all of the market losses.

This is the general goal of index funds or ETFs (electronically traded funds). ETFs aim to replication an index or a benchmark, either through owning all the same stocks or through sampling. Since the stock market as a whole will average a positive return over the long term, ETFs try to match that return (often coming up short due to several reasons).

ETFs are becoming ever more present in the world of investing, especially in the do-it-yourself sphere. Lets, for example, say that a portfolio holds 3 different Canadian ETFs. It is pretty common for many Canadian ETFs to be holding the same underlying assets (Banks, Oil/Gas, and Mining since these are the largest industries in Canada).

Even though a given ETF might have 20 underlying assets, there is still a good chance that they are concentrated in a small minority of industries. Most stocks in the same industry will have a fairly high correlation with each other. If the price of oil goes down it will probably bring the price of oil/gas stocks down and the price of mining stocks down as well.

So what is the answer then? Should you own as many different stocks as possible?

The short answer, no. If you own 300 different stocks you will probably dilute the risk that one of the stocks you own will dramatically underperform, but it doesn’t address the risk that the entire stock market might underperform.

Proper diversification

True diversification would seek to systematically reduce your overall risk by splitting up your investment asset and spreading them out based on the following criteria:

In Canada & around the world – A single country, even Canada, is a slave to its governing policy and consumer confidence. It is important to have a mix of investments from Canada and other countries around the world. As one economy slows, we may catch the rapid growth in another.

Across a variety of industries – It is difficult to predict where an industry may head with supply and demand, government regulations, and economic outlook. It is important to be invested in multiple industries to ensure we are not dependent on one particular industry to consistently grow.

A variety of securities or types of investments – There is no perfect investment for all time. While government and corporate bonds provide a steady and stable rate of return, the current low rates generally don’t generate enough return to keep our investments growing at a sustainable rate. Stocks may generate more dividends and capital appreciation than their fixed-income counterparts, but they do tend to fluctuate in value a lot more.

Are you properly diversified? If you’re unsure but curious, we’d be happy to review your situation.

Share your thoughts with us!

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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.

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