Tuesday, July 15, 2014

The Importance of Diversification - Part 1

Talk to any investor or financial advisor, and the rule of thumb to protect your assets is: diversification. This is part 1 of a two-part post where I discuss the importance of diversification. In this post, we look at the importance of diversification in investments. There are various complex mathematical models to determine risks in investments, which are outside the scope of this article and blog. For a simplistic viewpoint of risk assessment from a diversification viewpoint, consider the following chart (Image source: Nasdaq) comparing the Portfolio RiskGrade and the Number of Stocks.

Risk Grade vs. Number of Stocks

Risk can be either Unique or Systemic. As most investors know, investing in a company comes with a risk of the company either going under or just losing value, which results in the investor losing part or whole of his/her capital. This is called Unique risk. While investors can preserve their capital and investment by picking better companies, it is almost impossible to find a good investment without any inherent risk; as the old adge goes "Without risk, there is no reward". As illustrated in the graph above, studies have shown that risk can be mitigated by investing in as little as 12 companies, and close to elimination with approximately 50 companies.
Systemic risk may arise from common driving factors such as broad economic factors (for e.g., recessions), war, natural disasters etc. The broad markets move when such events occur. Note that even with a  globally diversified portfolio of stocks, there is still a risk-grade of 100 in the graph above. This is the systemic risk.

My Thoughts

When I consider diversification for my investments, I consider it on three different levels: diversification based on asset class; diversification by sector of the economy; and geographical diversification. Another old adage that investors should remember: "Never put all eggs in one basket".

  1. Asset class diversification is important for investors as relying on one asset class such as stocks, bonds, real estate or commodities exposes risk immensely. Stock market crashes of the yesteryears remind us how investor's fortunes were gained and lost. 
  2. Sector allocation: Investors should try to mitigate risk by investing in all sectors of the economy. I current own 20 individual stocks and 5 funds, which provides me with pretty good diversification. However, I still do not consider my portfolio completely balanced as it is lacking in certain sectors of the economy and it is an ongoing project on getting that balance right. Once I get it to a state I want it in, I will be cycling through my holdings and investing additional capital in the relatively undervalued stock/fund. 
  3. Geographical diversification: The type of diversification often overlooked by investors is the geographical diversification. A lot of investors believe in the mantra "invest in what you know". This, I find is a double edged sword. Yes, it is good to invest in companies that you know well if you are familiar with the business model and know how the company actually runs and turns profits and if the company has good future prospects. However, it is important to not depend only on your local businesses, but invest globally - esp now that we have all the tools available at our fingertips making trades available and affordable. This way, any local disturbances such as recessions, wars, natural disasters will not take a toll on your investments and the risk is mitigated.

Our Portfolio

As things stand, our portfolio is not so bad on the sector-wise asset allocation, but geographical diversification is very skewed to our home country (Canada). This big skew occurred after my wife and I merged our portfolios and all of her investments were focused on the Canadian markets. As part of my 2014 goals, we intend to rebalance our portfolios with better diversification.

What's Your Number?
I can think of a few finance bloggers who consider 40-50 stocks to be a number that makes them feel that their portfolio is well diversified. Dividend Mantra posted on this topic a couple of months ago where he makes the case for his portfolio to contain 50 stocks to achieve enough diversification. What are your thoughts? Do you have a number in mind? How many companies would you want to own before considering your investment portfolio diversified?

Full Disclosure: My full list of holdings is available here.

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