Diversification - “Don’t put all your eggs in one basket”

Diversification - “Don’t put all your eggs in one basket”

One of the main considerations our team factors into our investment decisions is diversification. Diversification can be best described by the statement “Don’t put all your eggs in one basket”. Too little and your portfolio will be too greatly affected by the individual changes of the corporations held in the account and too much you will not be benefiting from any stock selection. Investing is often considered both an art and a science and it is our job as portfolio managers to balance the two forms of risk in your portfolio – systematic and unsystematic risk.

A question that you might be asking is whether you should be taking any risk at all and leave your account in cash or guaranteed investment certificates (GICs). Wshile this may be good strategy for extremely conservative investors, there are many ways that we are able to reduce risk in your portfolio and earn a consistent return over a longer-time horizon. (Much like the sketch at the top of the article)

Systematic risk is the risk that is inherent in investing in a market. A product such as an EFT that is designed to replicate an index will only have market risk and will not benefit from individual changes in corporations other than how it affects the index. It is almost impossible to diversify.

Unsystematic is the risk of investing in a particular company. If the company was to underperform on earnings due to company specific issues and its share value was to decrease, this would be the manifestation of unsystematic risk. Unsystematic risk can also be increased to a sector level and country level. For example, if the oil price decreases it will have a large effect on oil producing companies and the Canadian market but have little effect on healthcare companies and the US financial markets. Unsystematic risk can be reduced through diversification. Too much diversification, your portfolio will end up replicating the market and not benefit from a security selection done by the portfolio manager.

The goal of a portfolio manager is to balance both of these diametric goals, providing stability through diversification and benefiting from our investment expertise to select high quality corporations that will outperform. We have found that the ideal number of companies in a portfolio is approximately 20-30 as it allows our clients to benefit from our security selection process while not “only betting on one horse.”

 
This process continues with our sector and country allocation process. Different countries and indices have different weightings as each country “specializes” in different industries. For example the Canadian markets are heavily weighted in financials, energy and materials companies. If you were only invested in Canada, you would have very little exposure to healthcare and technology companies that are dominant in the United States.


Finally, we look at diversification across asset classes, with bonds and stocks. Bonds and stocks traditionally have a negative correlation. Bonds tend to be much more stable an investment and are a safe haven in times of volatile stock markets; whereas stocks have higher returns over a longer time horizon but also significantly more risk.
As with diversification on an individual stock basis, our team’s goal is to create diversified portfolios that are not over exposed to any one particular risk and allows you to stay invested during times of financial market volatility to reach your longer term investment goals.

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