Proper Portfolio Diversification
Once upon a time a topiary artist invested all his money in shears and hedge funds. But he lost all of it because he wasn’t properly diversified. We diversify our assets so if one investment fails miserably it won’t drag down the rest of our portfolio with it. Owning 10 stocks is better than 1. But there comes a point when adding more stocks to a portfolio ceases to make a measurable benefit. Many experts suggest that optimal diversification is achieved when an investor holds 15 to 20 stocks spread across various sectors of the economy. 🙂
So if our portfolio contains 100 different stocks in 10 different industries then we are properly diversified right? Hold the mayo. I would argue no. Although we have a wide range of stocks and sectors, we really only have one asset class – stocks. Common stocks represent equity in publicly traded companies. But if a business becomes insolvent then its equity could be completely wiped out. This is why we have other asset classes such as bonds, which gives investors some recourse in a liquidation situation.
Okay, so diversification means having a balanced portfolio of index funds with both stocks and bonds right? Well, not quite. The capital markets can be highly volatile and it operates on a system that isn’t always reliable. In 1914 the US stock market shut down for 4 straight months. More recently in 2001 the NYSE was offline again for several days. This means at any time investors could be locked out of the market without warning. So other than financial assets, we can also invest in hard assets such as real estate, private businesses, gold, or other commodities. Over the past 2 decades Canada has gradually lowered interest rates and loosened borrowing rules, which encouraged consumer borrowing. This made the cost of living more expensive, especially in larger cities. But those who bought homes in Toronto circa 1996 and kept it until now would have seen their home prices rise to keep up with, or even surpass the inflation rate.