Time to Play Some Defence with Diversification
When I think of diversification I always get the idea of visiting a tapas bar with some friends. The idea behind a tapas bar is that you try many dishes with a big group so everyone gets to taste everything. If one or two dishes are not to your taste – its alright because they are so many different dishes to try. The portions may not all be large but sufficient enough to quench your appetite.
When I think of diversifying a portfolio – the same thought comes to mind. You want to structure your portfolio in a way where you have a footing in all the avenues. Not a big holding that if it performs poorly you will regret it but a sizeable one so that if the holding performs above par you share in the riches. Diversifying is a critical tool for fundamental portfolio design and a great way to see the benefits of numerous products. There are 2 general methods in how this can be accomplished.
If there is one term, diversification boils down to it would have to be risk. The whole premise of diversification is to mitigate risk as much as possible and having a solid portfolio that can withstand short term windfalls and succeed in the long term.
1. Diversifying with Risk or Asset Allocation
Diversifying with risk implies the old adage of investing which states 100-Age should equal the percentage of your assets in equities. If you’re 21 then you should be 79% invested in the stock market. Equities is just a fancy word for stocks. The reason as to why this rule applies is because younger people are recommended to take on more risk because of their future earning potential. However, the more I interact with people, their more I find they are risk averse and its normal because many millennials don’t know a lot about investing and are de-motivated by this. It doesn’t help that financial gurus preach the high risk high reward motto that causes a lot of people to chase yields rather then value. What’s important is that you are invested regardless of the risk level. Its natural that some people are less risky then others which is fine – the whole idea is to have a balance and have exposure to different asset classes to share in the gains. Asset Allocation, is the whole idea of balancing your holdings according to your risk tolerance levels and finding a good balance that also gives you a good rate of return, taking into considerations your goals and time frame.
What’s important to note, is that every tier, has some exposure to equities (except the extremes). If you ask me both extremes are equally risky. Keeping your assets mostly in fixed income (like GIC’s) and cash are both equally risky. Fixed income holdings are generally less risky and liquid but the yields can be terrible. You will grow your money albeit very slowly.
What do I do?
Day-Day: Cash Holdings
Emergency Fund: GIC’s
Long Term Savings: Mutual Funds, Stock and ETF’s
If you would like some help figuring out your own asset allocation let me know in the comments or email me at firstname.lastname@example.org!
Diversifying within a single asset class:
While asset allocation is the most important kind of diversification – it is also important to diversify within asset classes such as stocks. Suppose I had 5,000$ to invest in the stock market. I could take all the money and buy 1 stock or I could buy multiple stocks with holdings of 1,500$ or 1000$. Neither strategy is better then the other, but the 1st one is like Russian roulette– if you choose correctly you’re golden. By splitting the loot, I also spread my risk. With multiple holdings it also allows me to buy different stocks across different industries. I could buy a dividend stock with 1500$, a growth stock with another 1500$ and so on and so forth.
Lesson in over-diversifying
Did you know that drinking too much water was also dangerous for you? The same thing applies to diversification – even though it is a great tool for portfolio building over diversifying is bad also. When I first started investing I used to take on holdings of a few hundred dollars and having many of them. What I quickly realized was that I needed all of these positions to perform well to achieve my desired rate of return. Also if I needed to sell all my positions I would incur many transaction fees in doing so.
The same applies to asset allocation, spread your risk across multiple asset classes but do not over spread it. Limiting your risk is good but you don’t want to shoot yourself in the foot by playing it to safe.
Disclaimer: All of the above information is my own personal opinion. Diagrams are for learning purposes only. Please consult with a licensed professional before making any financial decision. Please do your research before making any financial commitment.
Thumbnail Image: Source: Prosperity Management