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.
Alright, so if we buy stocks, bonds, real estate, and everything in between, then we are properly diversified right? Well, almost. We still have all our investments in one currency, and in one country. Purchasing a global fund that tracks the performance of stock markets around the world can help, but most investors would buy them in their local currencies, which may not be enough.
No nation is immune to currency collapse. Venezuela was once considered a rich country not long ago. But things quickly changed when the price of oil fell 50%. This year the consumer price inflation in Venezuela is set to hit 480%. And according to the International Monetary Fund, the inflation rate is projected to top 1,600% in 2017. Around 31 million people live in the country and there is a huge shortage of food. Over the past weekend over 35,000 Venezuelans visited the neighboring country Colombia to buy food and medicine. That’s taking cross border shopping to a whole new level. ? An investor in the Venezuelan stock market could see his portfolio double or even triple in price over the year! But due to runaway inflation he would actually be poorer because the value of his currency will have lost more than 90% of its value. So diversifying away from one’s domestic country is highly recommended.
It appears the proper way to truly diversify our investment portfolio isn’t very straight forward. But if we keep all these things in mind, we can do a better job of spreading out our risk and making wiser financial choices. 😀 Although it doesn’t guarantee against loss, diversification can certainly help us reach our financial goals while minimizing risk.
Random Useless Fact: