4. Asset Allocation & Diversification
“The safe way to double your money is to fold it over once and put it in your pocket.”-Frank Hubbard
“Wide diversification is only required when investors do not understand what they are doing.”-Warren Buffett
“When you leave your investments to chance, then all of a sudden you don't have any more luck.” -Pat Riley
“We believe that according the name 'investors' to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a 'romantic.'“-Warren Buffett
“The primary cause of investor failure is that they paid too much attention to what the stock market is doing currently”-Benjamin Graham
"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down."- Warren Buffet
“Don’t look for a stock to jump: Look for a stock that goes up step-by-step.”- Warren Buffet
“You should lose a dollar of your investments instead of losing your investments for a dollar.” -Olga Lefebvre
"Don't put all your eggs in one basket."
This must be the most famous piece of investment advice ever given. Diversification means spreading your money over more than one type of investment to provide greater security. Investment funds should be distributed among the major classes of assets (Cash, Fixed Income and Equities) as to minimize the risk. In the language of investments, it's known as asset allocation or asset mix.
Asset Allocation is one of the key principles of successful investing. Investment allocation is basically the financial strategy of investing money in various asset classes based on your investment profile like your goals, time horizon and risk tolerance. Spreading your money across many securities and industries is the only reliable insurance against the risk of being wrong, but diversification doesn't just minimize your odds of being wrong, it also maximizes your chances of being right.
Diversification can be accomplished through asset class mix, sector, geography, investment style , and by blending (low, medium and high) investment risk factors. The list goes on and on. There are many ways and combinations of ways to achieve diversification; the trick is to avoid over-diversification and keep it simple.
Too much diversification can be a problem. An over-diversified portfolio carries a risk by limiting your return performance and setting you up to pay mostly on running fees. When you have too many investments if a particular investment rises rapidly your overall gain is limited because this investment represents only a small portion of the portfolio. Proper portfolio diversification limits risk of loss without sacrificing potential gains, but over-diversification will do exactly the opposite and sacrifice your return.
Remember: Diversification can’t guarantee that your investments won’t suffer if the market drops. But it can improve the chances that you won’t lose money or that if you do, it won’t be as much as if you weren't diversified.
1- Asset Class diversification
This investment strategy diversifies a portfolio among different types of asset classes, such as cash, bonds, stocks, and other investments, each with different risk/return characteristics.
- Cash and Equivalents (offer security and safety of principal) With cash equivalent investments, you have the least risk but also the lowest potential returns because they are tied to short-term interest rates and generally consist of highly liquid short-term investments such as T-bills and money market mutual funds.
- Lending type of investments - Fixed Income (generate an income stream) With a lending (fixed income) investment, you are entering into a loan arrangement. You agree to allow somebody else – or some company – to use your money. In return, they pay you interest on your money at predetermined periods and at an agreed upon rate. Most lending arrangements also have a set term – after a predetermined period of time, the borrower will give you all your principal back again.
Usually these investments deliver slightly higher long-term returns than cash, however, they have a higher risk. Fixed income assets generally consist of GICs (Guaranteed Investment Certificates), bonds and other fixed income investments such as mortgage-backed securities.
- Ownership type of investments – Equities (provide long-term growth potential) With an ownership (equity) investment, you become one of the owners of that investment, as a result, you get to share in the profits. While they have the greatest potential returns over time, they also expose investors to the highest level of risk of any of the three asset classes.
Remember: A good start is to keep at least those 3 types of assets in your portfolio.
2- Sector diversification
In sectorial or specialized investing, you would hold a percentage of investments in certain industry sectors such as:
- Consumer Products Companies in this sector tend to be “defensive” or “non-cyclical”. This means they aren't very sensitive to economic swings and will continue to make a profit no matter what happens to the economy. Even in a recession, everybody still needs to buy the life essential products – things like toothpaste, band-aids, soup, bread etc. When choosing stocks from this sector look for “brand” awareness. Well recognized companies have a significant competitive advantage. Some examples include: Coca-Cola, Campbells, and Proctor & Gamble.
- Technology Despite the high-tech boom and bust, technology isn't going away. There’s no doubt this sector is volatile and will be affected by changes in the economy. So the key is to choose stocks that will reduce the volatility yet still let you participate in the significant growth potential in this sector.
Go with the gorillas! Out of the dozens of stocks to choose from look for large companies with a long and happy history. Some examples include: Microsoft and IBM.
- Health Care Similar to the consumer products sector, companies in the health care area are less affected by economic changes. People will continue to buy products and a service to help them get better or to manage illness, regardless of what’s happening in the economy.
Look for global companies with numerous products and “deep pockets” to finance research and development of tomorrow’s best-selling drugs and treatments. Some examples include: Pfizer and Merck.
- Finance Investing in financial services companies often brings the combined benefits of good dividend payments with more stable capital growth potential. Companies in this sector generally have multiple business lines including traditional banking and lending, insurance, wealth management, brokerage, and investment banking. Another thing to remember about financial services companies is this: falling interest rates generally mean rising profits (and share prices) for financial institutions. Conversely, their stock prices may falter when rates are rising. Some examples include: RBC and Bank of America
- Energy Why energy stocks? One reason is that energy stocks often move independently of the larger stock market. Inflation, for instance, is a general enemy of the overall market, which doesn't like rising prices. But often a key factor in rising cost of living is higher energy prices. So the market may not like inflation, but during inflationary times energy companies may be more profitable.
Oil stocks are often where investors will run for shelter when the energy sector turns down. Some examples include: Exxon Mobil, and Suncor.
- Utilities Of all the sectors we've looked at, this sector is the “odd” one out. The difference is this: the stocks of utility companies like phone, electrical and gas-pipeline companies traditionally don’t move much in price. It’s the dividends they pay that makes them attractive to investors. Prices for their products and services are still largely regulated. That means stable growth and predictable earnings which translates into strong and steady dividends.
Remember: If you're not willing to do your homework regarding the investments you’re buying, you should get out of the stock picking business and stick with index funds.
3- Geographic diversification
In regional or geographical investing, you would hold a percentage of investments in certain regions, such as:
The Pacific Rim, Latin America, North America and Europe. These regions represent roughly 97% of the investment opportunities that exist in today's global marketplace.
The United States, Japan, United Kingdom, Hong Kong, China and Canada alone, represent roughly 70% of the stock markets.
Similarly the emerging markets like the BRIC (Brasil, Russia, India and China) can represent roughly 20% of the global marketplace.
Remember: This is not based on their gross domestic product (GDP), but on the market capitalization of the companies listed in their stock exchanges.
4- Style diversification
- Active vs. Passive Active investors believe in their ability to outperform the overall market by picking the right stocks at the right time. They don’t believe in Efficient-Market Hypothesis (EMH), they believe that the flow of information is not evenly distributed and there are always hidden opportunities in the stock market. Keep in mind that active investing requires taking time to do research and buying and selling stocks frequently, this consequently will end up increasing your cost of operation as you move in and out of the market.
Passive investors believe in long-term investment appreciation and limited maintenance, avoiding the possible consequence of failing to correctly pick the right stocks at the right time. Passive investors believe in Efficient-Market Hypothesis (EMH), they believe that the flow of information is evenly distributed and there are no hidden opportunities in the stock market or at least that these opportunities cannot be predicted. Keep in mind that the passive investing idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future.
Comparatively to the Active investor the Passive investor’s aim will be the freedom from efforts, information overload annoyance, and the need to make frequent decisions. Simply investing in exchange traded fund (ETFs), index funds or mutual funds will produce higher results over a long period of time.
Remember: Each and every year, studies are done comparing the returns of actively managed funds to the returns of passive funds. Each year, studies show that actively managed funds rarely have returns higher than their passive counterparts.
- Growth vs. Value Value investing generally looks for stocks that are “cheap”- a bargain stock is one that is often out of favor, such as cyclical stocks that are at the low end of their business cycle. A value stock is primarily a company selling below its intrinsic value. Basically it is a stock with a low price compared to its underlying cost of replacement or liquidation.
One way to determine whether a stock is worth more than what it is trading for is its price-to-earnings (P/E) ratio. You get this number by dividing the share price by the company profits per share found in their annual report. You usually compare this number with the company’s P/E history, other similar companies and the stock market as a whole.
Growth investing generally look for stocks with perceived future growth potential. A growth stock is primarily focused on rapidly growing its sales and profits and consequently affecting its share price
One way to determine whether a stock has a growth potential is to look at the companies earnings per share (EPS). You get this number by dividing the total earnings by the number of its common shares outstanding found in their annual report.
Remember: Returns on growth stocks and value stocks are not highly correlated. By diversifying between growth and value, investors can help manage risk and still have high long-term return potential.
- Small Cap vs. Large Cap. Some investors use the market capitalization of a company as the basis for investing. “Market Cap” is basically how big the company is. While there is no official breakdown, the division between them is approximately:
Small-cap: $100 million-$1 billion; these companies have higher price volatility, which translates into higher risk, but those smaller companies can often offer more growth. These companies tend to be the new start up companies with bright new ideas. This is where you would find the “Penny stocks”
Mid-cap: $1 billion-$10 billion; Here is where some investors choose the middle ground seeking a trade-off between volatility and return.
Large-cap: $10 billion and greater; these big companies tend to be less risky than small ones, and they are generally well-established and financially sound and have operated for many years. These companies tend to be the market leader or among the top three companies in its sector and is more often than not a household name. This is mostly where you would find the “Blue Chips stocks”
Remember: How you distribute the money you’re investing is more important than the actual investments you purchase. Don’t put all your eggs in one basket! It’s been said that up to 90% of your overall return is determined by how you allocate your funds.
Where to invest to cover all bases?
Two of the best financial inventions of the past half century are the low-cost index fund and its younger relative, the index exchange traded fund (ETF). Index funds and ETFs are a good place to start for beginner investors and they offer great benefits like:
Asset Allocation: Index funds give you control of your exposure to the specific asset classes you want. It’s easy to find index funds focused on the main asset classes like fixed income, real estate and equities.
Geographic Diversification: In today’s globalization industries, companies and even countries are highly interconnected. In this global economy your money may be better protected if you invest in other countries rather than just your own.
Diversification: You get wide diversification in a single package. Contrary to popular belief, investors benefit from owning more stocks, not fewer. By including all the stocks in an asset class such as large-cap or value orientated companies, an index fund can give that advantage to their shareholders. Studies show that owning more stocks will probably increase your return, and it will certainly reduce your level of risk.
Accessibility & Affordability: ETFs are easy to buy and sell as necessary and often they have low investment minimums, making them accessible to nearly everyone. However, redemptions may be subject to fees or commissions, and restrictions may apply, like a holding period.
Convenience: Investment funds are ready-made investment portfolios that are easy to implement, to manage and to achieve your financial goals. Once you have found index funds in the asset classes you want, you don’t have to do anything. The only exceptions are adding new money, withdrawing money, periodic rebalancing and occasionally changing the mix of your own asset allocation.
Professional management: You won’t have to worry about monitoring the performance of an index fund manager. The index fund manager’s job isn't to scour the world for good stock picks but simply to mirror the index. This is a simple, inexpensive and passive approach to investing.
Endorsed: Index funds are favored by Nobel Prize winning economists, Warren Buffett, John Bogle, Charles Schwab, almost all academics, the largest U.S. pension funds, and almost every fiduciary adviser.
Transparency: When you buy an index fund, you know what you’re getting - the performance of an index. The manager’s only stock-picking role is strictly mechanical; to mirror what is in the index. This is simple, inexpensive, and it’s very easy to compare your performance with that of its index; they should be extremely close.
Stable growth: You will most likely get above-average returns. Of course there is no guarantee, but if you buy an index fund and hold it for the long term, your return is likely to be among the top 10% of all returns for funds in that asset class. That’s very good. In fact, it’s great!
Risk Management: Your money is pooled with the money of many other people who have similar investment goals to buy many individual companies with different investment profiles into one fund.
Rebalancing: Index funds are easy to rebalance compared to an individual stock portfolio on a regular schedule without worrying whether, by selling, you will miss out on a manager’s “hot streak.”
Cost efficiency: Index funds have low operating expenses. An index fund has no need to pay a staff of analysts to travel the world looking for exceptional “deals” or to hover over computer screens trying to figure out the economy. Consequently Index funds have low internal trading expenses and they have a very low portfolio turnover because they simply don’t trade very often. Index funds sometimes charge only one-tenth as much as actively managed funds in the same asset class. Those savings go to shareholders.
Tax implication: Because of their lower turnover, index funds reduce your tax exposure. Sometimes an actively managed fund can hit you with nasty, unexpected tax consequences. For example, a manager may sell a position in a stock the fund has owned for years, leaving shareholders with a large capital gain. In a taxable account, you are liable for your share of that tax even if you owned the fund for only a week.
Index funds & Exchange Traded Funds
The quick and easiest way to invest instead of the time consuming research and stressful stock-picking strategies is to invest directly in the whole market.
Every stock market index has an equivalent index fund or ETF that you can buy for your own portfolio, here are a couple of examples:
How to get there from here (Asset Allocation & Diversification):
Asset Class diversification; what percentage would you allocate to the following?:
___ - Cash and Equivalents (offer security and safety of principal) _______%
___ - Lending type of investments - Fixed Income (generate an income stream) _______%
___ - Ownership type of investments - Equities (provide long-term growth potential) _______%
Geographic diversification; what percentage would you allocate to the following?:
___ - American _______%
___ - Domestic _______%
___ - International _______%
Style diversification; what style of investing would you choose?:
___ Active or Passive __________________
___ Growth or Value __________________
___ Small Cap or Large Cap __________________
Here’s my conclusion, developed from my experience with investments. The only way to protect yourself against systematic risk is to diversify by taking into consideration asset class and geographic diversification to take advantage of the dynamic globalization of economies. Over and over again studies have proven that a passive approach to investing will outperform any active trader over time and the best equities to achieve are the large cap value companies also known as “Blue chips”. EFTs or mutual funds are an easy way to diversify your portfolio simply because those investments are already diversified in and of itself and you don’t need many of them to be well diversified.