Portfolio Diversification

[kn]

I'm reading varied thoughts on what is sufficient diversification. Is there such a thing as too much diversification?

Benjamin Graham, who wrote several books and was the mentor to Warren Buffet, suggests in the "Intelligent Investor" that a representative list of 30 blue chip companies is sufficient diversification for the defensive investor.

I've read articles profiling average Canadians who've made a successful retirement portfolio by juggling no more than 10-12 stocks.

Scott Burns, one of the early advocates of passive investing, shows how following an indexed strategy of 50% bonds and 50% in a fund tracking the S&P 500 is all you need:
http://assetbuilder.com/blogs/scott_...-investor.aspx

MoneySense magazine, which just released the "Guide to the Perfect Portfolio" suggests index funds or ETFs covering a minimum of four asset classes - Canadian bonds, Canadian equity, US equity, and International equity. Within each of those equity funds are thousands of companies. If you add emerging markets or commodities, or pick a fund that attempts to cover the "Total Stock Market", you're probably dealing with over 10,000 companies.

The opposite (as far as ETFs are concerned) is DIA which covers the 30 companies making up the Dow and XIU which covers the top 60 companies on the TSX:
https://www.spdrs.com/product/fund.seam?ticker=DIA
http://ca.ishares.com/product_info/f...erview/XIU.htm

For a long-term buy-and-hold strategy, would investing in these two funds be sufficient? You're still investing in 90 companies, something virtually impossible to do directly.

I think I'm reaching the point of information overload and paralysis by analysis in determining how I want to structure my portfolio.

[Ozy_Flame]

That's some pretty detailed personal planning. Are you sure you don't just want to talk to a respected financial planner who can cater to your needs?

(Half of what you wrote is like a complete foreign language to me, and I went through business school. I wouldn't even know where to start with any of this lol . . . )

[Slava]

There are a couple of different strategies in general: don't put all your eggs in one basket and the other is put all your eggs in one basket and watch the basket.

I've become increasingly a fan of the put all your eggs in one basket route for a number of reasons.

I'm not a fan of passive investing in general, but to each their own.

[MarchHare]

For the long-term "buy & hold" investor, I really see no reason why you shouldn't invest in a few index funds and ride the market. Adjust your portfolio at certain stages of your life as your risk tolerance changes (i.e. weigh equities heavier than bonds while you're younger and vice versa when you're older).

[Senator Clay Davis]

Spoiler!

[kn]

Thanks for the responses.

I'll admit to being tempted by DIA and XIU even though I know they're not completely representative of the market. I figure if 30 stocks is good enough for Graham, then 90 stocks is good enough for me to cover two major asset classes.

Still debating whether I need to invest outside North America for "diverstification" and whether currency hedging is something I want to consider despite the greater MER and tracking-errors...

[MarchHare]

Originally Posted by kn

Thanks for the responses.

I'll admit to being tempted by DIA and XIU even though I know they're not completely representative of the market. I figure if 30 stocks is good enough for Graham, then 90 stocks is good enough for me to cover two major asset classes.

Still debating whether I need to invest outside North America for "diverstification" and whether currency hedging is something I want to consider despite the greater MER and tracking-errors...

I'm at best an amateur investor, so don't take this advice as coming from a professional. That said, I'm figuratively putting my money where my mouth is with what I'm about to post:

If you're relatively young, have a portfolio consisting of four simple index funds (remember to rebalance every year): 25% Canadian equities, 25% US equities, 25% international equities, 25% Canadian bonds. You'll have excellent diversification across different asset classes, industries, and geographies. Don't bother worrying about your day-to-day portfolio valuation. You're investing for ~20-25 years at this point, so you can expect a large amount of volatility but a steady rise in value over the long term (an average ROI of 5-10% per year is a reasonable assumption).

As you reach middle-age (say age 45+), adjust your portfolio to have a lower percentage of equities (more volatile, higher risk/higher reward) and a greater percentage of bonds (less volatile, lower risk/lower reward).

When you get close to retirement (60+), switch entirely to asset classes that have very low risk like GICs. If the market crashes when you're 63, you don't have many more working years to recover if you're still heavily invested in equities at that age.

[cral12]

On this note, any financial advisor recommendations (that don't involve sending bank account info to Nigeria for a $35,000,000 winfall...lol)?

Thanks

[Slava]

Originally Posted by kn

Thanks for the responses.

I'll admit to being tempted by DIA and XIU even though I know they're not completely representative of the market. I figure if 30 stocks is good enough for Graham, then 90 stocks is good enough for me to cover two major asset classes.

Still debating whether I need to invest outside North America for "diverstification" and whether currency hedging is something I want to consider despite the greater MER and tracking-errors...

Well there is a point of departure here though; 30 stocks was enough for Graham but it wasn't just 30 stocks to try to represent an index. Graham was researching and finding a specific 30 stocks.

[Slava]

Originally Posted by MarchHare

I'm at best an amateur investor, so don't take this advice as coming from a professional. That said, I'm figuratively putting my money where my mouth is with what I'm about to post:

If you're relatively young, have a portfolio consisting of four simple index funds (remember to rebalance every year): 25% Canadian equities, 25% US equities, 25% international equities, 25% Canadian bonds. You'll have excellent diversification across different asset classes, industries, and geographies. Don't bother worrying about your day-to-day portfolio valuation. You're investing for 25+ years at this point, so you can expect a large amount of volatility but a steady rise in value over the long term (an average ROI of 5-10% per year is a reasonable assumption).

As you reach middle-age (say age 45+), adjust your portfolio to have a lower percentage of equities (more volatile, higher risk/higher reward) and a greater percentage of bonds (less volatile, lower risk/lower reward).

When you get close to retirement (60+), switch entirely to asset classes that have very low risk like GICs. If the market crashes when you're 63, you don't have many more working years to recover if you're still heavily invested in equities at that age.

Well I'm an advisor and I completely disagree with this. I know, it sounds sensible and there are definitely a lot of advisors who would tell you this kind of lifecycle planning is the way to go. There are some huge flaws though.

Firstly, the entire concept of risk/reward in the financial world is largely garbage. It is the great quest of finance professionals everywhere to breakdown the risk of each asset to a number or quantify why this investment is higher risk than the other. Can it be done? Well sort of. The reality is that investments of different types are riskier at different times. There were periods where being invested in bonds or typically lower risk investments were riskier than being is stocks and vice-versa. There are many different ways in which risk might be characterized, but they all equate to losing money. That is what risk is.

So why is it silly to change the equities you are holding as a result of your age? Well lets say you are going to retire at age 65 and you want $1M in the bank. The fact is that even if you hit your goal here you don't need those funds the day after you turn 65 years old. Its great, but presuming you live now until age 90 some of those funds are sitting there for another two decades! Why you would do anything other than what a sensible investor would do with money for twenty years at that time is somewhat perplexing.

I completely understand that people don't like to lose money. Its disheartening to put money in an investment today and get a statement showing a loss six months down the road. I'm not for a second advocating that investors should be running around buying penny stocks or anything like that, but taking all of your risk off the table isn't the way to go either IMO.

[MarchHare]

I completely understand that people don't like to lose money. Its disheartening to put money in an investment today and get a statement showing a loss six months down the road. I'm not for a second advocating that investors should be running around buying penny stocks or anything like that, but taking all of your risk off the table isn't the way to go either IMO.

Do you not agree that people have different tolerances for risks at different ages, though? If I lose half of my retirement savings while I'm in my 30s, I'm not overly concerned about it because I have plenty of working years left in my career to make it back. My grandmother, on the other hand, doesn't have that luxury. She needs to know that her investments are safe and will provide her with a steady, predictable income for the remainder of her life.

[Slava]

Originally Posted by MarchHare

Do you not agree that people have different tolerances for risks at different ages, though? If I lose half of my retirement savings while I'm in my 30s, I'm not overly concerned about it because I have plenty of working years left in my career to make it back. My grandmother, on the other hand, doesn't have that luxury. She needs to know that her investments are safe and will provide her with a steady, predictable income for the remainder of her life.

I agree with that. i suppose my disagreement is more with how that risk is characterized and disclosed to the client. There are a lot of bonds and fixed-income instruments that are much higher risk than a lot of equities. When a client hears bonds/fixed income they think its low risk....which might be the case. I can tell you that I would rather own shares in some companies than the bonds of others though if that makes sense?

[Cowperson]

Originally Posted by MarchHare

Do you not agree that people have different tolerances for risks at different ages, though? If I lose half of my retirement savings while I'm in my 30s, I'm not overly concerned about it because I have plenty of working years left in my career to make it back. My grandmother, on the other hand, doesn't have that luxury. She needs to know that her investments are safe and will provide her with a steady, predictable income for the remainder of her life.

You can actually have a "steady, predictable income for the remainder of her life" with a 100% equity portfolio as well.

I know people in their 30's who are 100% GIC's and people in their 70's and 80's who are 100% equity.

Everyone is different. You Manage your emotions through asset mix and try to never depend on capital gains for a required income stream. If you do have the 100% equity approach, any income you need should be fully funded by dividends, rendering the ups and downs of markets moot in the near or even longer term.

Remember that one-third of rate of return since the 1950's has come from dividends. Cash flow, money coming into the portfolio, is extremely important to total rate of return and, as a byproduct, to controlling volatility and your emotional state. We forgot about that in the 1990's a bit but its never been truer since 2000.

Manage emotions through asset mix. Never fund any part of a required income stream with an expectation from capital gains.

Cowperson

[MarchHare]

I can tell you that I would rather own shares in some companies than the bonds of others though if that makes sense?

Sure, I imagine everyone agrees that owning shares in a blue-chip stock is a much safer investment than trading in junk bonds. I didn't intend to give the impression that all bonds are always lower risk than all equities, so my apologies if my post sounded that way.

I was speaking more in generalities, not specifics. If you invest in an index fund that tracks the TSX/S&P Composite Index and another index fund that tracks the DEX Universe Bond Index, over a long period you're likely (but obviously not guaranteed) to see the former yield a larger return but be more volatile in any given year while the latter will have fewer large peaks and valleys but a lower long-term ROI.

[Phanuthier]

As a key point (and some noted above) Ben Graham says key companies, not key funds. As Slava said, I don't see things as a "risk tolerance" per say, but I do watch how each of the stocks I have perform under different economic environments. Forget the term "risk tolerance" - if you think a company is gonna die, don't buy it. Buy stocks you believe in and should survive a few economic cycles at worst. How that translates to funds.... not sure. I don't invest in funds directly (just through my 401k).

[SeeGeeWhy]

Read poor charlie's almanack - an evolution of Ben Graham's principles as put into practice. For instance, Munger and Buffett only invest in companies they can understand. You don't diversify at the cost of investing in something you do not understand.

Diversification is a strategy to mitigate against risk, but you have to ask yourself - what is the risk I am protecting against? Security is about bolstering what is most important and leaving the rest exposed to what may happen.

My opinion, you're blending systemic risk (overall market risk) with more specific risks. You can diversify against market risk by investing in specific instruments and having a long time horizon. You can diversify against sector or company specific risk by dividing your capital in complimentary sectors or with complimentary competitors within a sector for instance, but you'll typically more exposed to systemic shocks as your play is shorter term and generally more exposed to such things as... eurozone economic policy effecting global markets.

So - what kind of risk are you trying to protect against? What is your desired rate of return? What is your time horizon for that return? These are all things you should have an idea on before you can start knowing how to diversify your holdings.

[Northendzone]

Originally Posted by Slava

I've become increasingly a fan of the put all your eggs in one basket route for a number of reasons.

I am all in on a company called research in motion - Canadian tech companies never miss......