Diversification

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The simplest example of diversification is provided by the proverb "Don't put all your eggs in one basket". More specifically, diversification means reducing non-systematic risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituent.[1]

Diversification is one of two general techniques for reducing investment risk. The other is hedging. Diversification relies on the lack of a tight positive relationship among the assets' returns, and works even when correlations are near zero or somewhat positive. Hedging relies on negative correlation among assets, or shorting assets with positive correlation. Hedging techniques are generally the domain of institutional investors and sophisticated investors and therefore is outside the scope of this article and likely this wiki.

Diversification can be done through asset allocation by combining different asset classes. It can also be done within asset classes, either geographically (see Global diversification) or by adding more securities or sectors, to eliminate unsystematic risk.

Canadian capital markets represent a small fraction of global capital markets: in 2012 Canada represented 2% of the global bond market,[2] and Canadian equities represented 3% of world stock markets at the end of 2013.[3]

Asset allocation

History has shown that different asset classes provide different returns. While past performance is not an indicator of future performance, the three main asset classes - equities, fixed income, and cash and equivalents - have different levels of risk and return, so each will behave differently (i.e. they are not perfectly correlated) over different periods and market and economic conditions, so diversifying portfolios across asset classes will help to optimize risk-adjusted returns.[4]

Equities

The following two sections deal with sector concentration and index concentration in the Canadian stock market, and ways to address this issue. The subsequent section deals with how many many stocks are needed for a diversified portfolio, in general. Sectors are defined by the Global Industry Classification Standard (GICS).

Sector concentration and index concentration

For Canadian investors, one of the diversification challenges is that the Canadian stock market is far less diversified than the US or other foreign developed markets. The Canadian stock market is highly dependent on just three sectors:[5][6] financials; energy (oil and gas); and materials (gold and mining). Therefore, an investor who purchases only Canadian equities may have insufficient sector diversification. This can be seen in the following table:

Sector weights for Canadian and US markets
As of close-of-market December 30, 2016[7][8]
GICS® Sector S&P/TSX Composite
(Canada)
S&P Total Market Index
(US)
Financials 35.0 15.4
Energy 21.4 7.0
Materials 11.8 3.3
Industrials 8.9 10.9
Consumer Discretionary 5.0 12.5
Telecommunication Services 4.8 2.4
Consumer Staples 3.8 8.3
Real Estate 3.0 4.1
Health Care 0.6 13.1
Information Technology 2.7 20.0
Utilities 2.8 3.2

It is also possible for a single stock or small number of stocks to dominate the Toronto stock exchange. Nortel was 36.5% of the TSX on July 26, 2000, before eventually becoming bankrupt in 2009.[9] Although the index methodology has since been changed to limit the holdings to 15%,[10] the relatively small size of the Toronto market still leads to a heavy concentration of the index in a relatively small number of stocks: the top-ten companies made up 36% of the index at the end of 2014. For comparison, at the same date, the top-ten constituents made up 18% of the S&P500 index, 13% of the MSCI EAFE index, and 9% of the FTSE All-World ex Canada Index (see Equity indices).

Diversification strategies

There are several ways to deal with the lack of diversification of the Canadian stock market. All have drawbacks or associated costs. Several of these may be used in combination.

  1. Accept the lack of diversification. This means having little exposure to other sectors like consumer staples.
  2. Use additional broad equity index funds or exchange-traded funds (ETFs) from other countries (see Global diversification). Depending upon the amounts involved, this may expose the investor to wishes to live and retire in Canada to currency risk, since most of their expenses will be in Canadian dollars.
  3. Use currency-hedged ETFs or mutual funds. This adds additional costs.
  4. Use an actively-managed Canadian equity fund rather than an index fund or ETF. This adds additional costs and the fund or ETF may or may not outperform the index.
  5. Select individual stocks to maintain sector balance. For some sectors not well represented in Canada, the US market may provide a better hunting ground. Stock picking adds the risk of underperformance, as well as additional costs.

How many stocks?

A classic question is how many stocks is takes to create a diversified portfolio, i.e. how many stocks are needed to eliminate, mostly or completely, the unsystematic risk. A commonly held belief is that 15 or 30 stocks is good enough. From a volatility perspective this is true: portfolios of 30 stocks will not be much more volatile than a broad market index.[11][12] But this ignores the terminal wealth question. In The Four Pillars of Investing, Bernstein[13] examines 1000 random portfolio of 15, 30 and 60 US stocks over a period of 30 years. The results for the 15 stock portfolios are the most dramatic: those in the 5th percentile of performance returned 2.5 times the market (S&P500) terminal wealth. But the portfolios in the 95th percentile returned only 40% of the market terminal wealth (40 cents for each dollar). This

...demonstrates the central paradox of portfolio diversification. Obviously, a concentrated portfolio maximizes your chances of a superb result. Unfortunately, at the same time, it also maximizes your chance of a poor result. This issue gets to the heart of why we invest. You can have two possible goals: one is to maximize your chances of getting rich. The other is to minimize your odds of failing to meet your goals or, more bluntly, to make the likelihood of dying poor as low as possible. (…) these goals are mutually exclusive.

A common criticism of such arguments is that almost nobody picks stocks randomly: investors have methods to select what they think are the “best” stocks when building portfolios. But a counter-point is that the results of the broad market index are greatly influenced by a few “superstocks”:[11]

a grossly disproportionate fraction of the total return came from a very few "superstocks" like Dell Computer, which increased in value over 550 times. If you didn’t have one of the half-dozen or so of these in your portfolio, then you badly lagged the market.

Fixed income

Diversification within fixed income portfolios can take several forms.

Diversification by types of fixed income

At the most general level, diversification in a fixed income portfolio can mean combining different asset subclasses such as guaranteed investment certificates (GICs), nominal bonds, and real return bonds (RRBs). These subclasses of fixed income have different risk-return characteristics, and are unlikely to be perfectly correlated with each other. The rest of this section deals with investment-grade nominal ("conventional") bonds only. For high-yield (junk) bonds, investors should use an ETF/mutual fund to get appropriate diversification.

Geographic diversification

Investment-grade nominal bonds can be domestic (Canadian) or foreign (global). Combining domestic and foreign bonds has theoretical diversification benefits, but there are issues such as currency exposure and additional costs that come into play with foreign bonds. See global diversification and foreign bonds.

Diversification by maturity

Bonds can be purchased individually or in bond funds (mutual funds including index funds; ETFs). One popular bond management strategy is laddering: a ten year ladder has bonds maturing in one year, two years, three years, and so forth up to ten years. Purchasing bond funds, or building a ladder, both spread out maturities in order to smooth out interest rate fluctuations and address reinvestment risk ("the risk that future coupons from a bond will not be reinvested at the prevailing interest rate when the bond was initially purchased"[14]). Bonds of different maturities react differently to interest rate fluctuations: short bonds are less sensitive than medium term and long bonds. Specialized ETFs are available for short, medium term, and long bonds.

Bond diversification by issuer

Bond funds are generally broadly diversified by issuer. For example, ETFs that follow the universe index contain hundreds of government and corporate issues. But some investors prefer to purchase individual bonds, and in this case the topic of diversification by issuer becomes important. In general, the need for diversification by issuer depends on riskiness of the issuer. For example, a 10 year ladder containing only bonds from the Government of Canada is 100% concentrated in a single issuer, but the AAA rating means perfect safety (and low yields). Provincial ladders with five or more issuers are probably safe as well.

Issuer diversification for corporate bonds

Corporate bonds are trickier. For a ten year investment-grade corporate ladder, are ten issues really enough? From a variance perspective, yes:

"The portfolio sizes frequently mentioned as being "enough" to obtain adequate diversification with common stocks – eight to 16 issues – also seem appropriate for bonds, as eight bonds realize a minimum of 0.83 and 16 bonds a minimum of 0.92 of the potential risk reduction obtainable via diversification"[15]

But what if one company is downgraded to junk status or even defaults? Taking default risk into consideration, Hymas recommends a minimum credit quality of A(low) on individual corporate bonds, because "it is quite rare for an “A” rated bond to default"[16], and "15-20 unrelated names"[17]. These issues should come from different sectors (financials, utilities, ...). Buying 15-20 corporate bonds at reasonable bid-ask spreads will likely require a large amount of capital according to Hymas:

"If you have more than $1-million, then you can talk about buying individual issues, but if you have less than $1-million you’re either going to have poor diversification or poor pricing, perhaps both."[18]

See also

References

  1. Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 273. ISBN 0-13-063085-3
  2. Going global with bonds: Considerations for Canadian investors, Vanguard research, January 2014. Viewed January 19, 2015.
  3. Credit Suisse Global Investment Returns Yearbook 2014, viewed January 1, 2015.
  4. Larrabee, David, Setting the Record Straight on Asset Allocation | Enterprising Investor, CFA Institute, 16 February 2012. Viewed January 6, 2015.
  5. MSCI Indices, Global Industry Classification Standard (GICS®) Structure - GICS - MSCI, retrieved November 28, 2012.
  6. iShares Canada, XIC Overview: Sector Breakdown, viewed May 22, 2012. Sector breakdowns as of that date were: Financials, 31.59%; Energy, 25.76%; and Materials, 18.52%.
  7. Standard and Poors, S&P/TSX Composite, viewed January 4, 2017.
  8. Standard and Poors, S&P Total Market Index, viewed January 4, 2017.
  9. CBC News, Nortel's Icarus-like stock, January 15, 2009.
  10. Wikipedia, S&P/TSX Composite Index, viewed May 30, 2012.
  11. 11.0 11.1 W.J. Bernstein, The 15-Stock Diversification Myth, viewed January 19, 2015
  12. J. Whitby, The Illusion Of Diversification: The Myth Of The 30 Stock Portfolio, viewed January 19, 2015
  13. W.J. Berstein, The Four Pillars of Investing, McGraw Hill, page 100-101
  14. Investopedia, Reinvestment risk definition, viewed January 27, 2015
  15. R.W. McEnally & C.M. Boardman, 1979, Aspects of corporate bond portfolio diversification, Journal of Financial Research, v. 2, p. 27–36, DOI: 10.1111/j.1475-6803.1979.tb00014.x (typo in the original source corrected: "seen" changed to "seem")
  16. J. Hymas, The Bond Portfolio Jigsaw Puzzle, Canadian Moneysaver, November-December 2009, pages 26-28
  17. J. Hymas, Credit Spreads and Default Risk, Canadian Moneysaver, July-August 2009
  18. J. Hymas, quoted in Why only millionaires should invest in bonds directly, Globe and Mail, July 6, 2011.

Futher reading

External links