By Jason Sirman
Joe is a star running back who has just signed a multi-million-dollar contract and is ready to play in his first game. While he understands that there is a risk of injury every time he steps on the field, he has also concluded that the multi-million-dollar contract is enough to justify the risk.
Joe also has a new hobby – trading investment securities using his newfound wealth. He has read that to increase the expected rate of return on his investments, he needs to increase the risk in his portfolio. He decides that to do this, he needs to trade individual stocks. Not wanting to spend a lot of time researching, he buys shares in a few companies he recognizes – two banks and an oil and gas business, all large Canadian companies that have been around since before he was born. Now, he concludes, he will experience the higher rates of return that come with increased risk.
Diversification is not defined by how many stocks or funds you own. A diversified portfolio should be structured to hold multiple asset classes that represent different market dimensions across the world.
Joe has decided to concentrate his money in three stocks. Basically, he is betting on those three and against the rest of the available stocks. What Joe has failed to understand is that although he has increased the risk of his portfolio, he has not increased the expected rate of return. The expected rate of return of each individual stock is the same as the expected rate of return on the market portfolio (not including the impact of fees or over/underweighting of different classes of stocks). Is there a chance that these stocks could outperform the market portfolio? Certainly, but research shows that it is very difficult to predict which stocks will outperform the market portfolio.
Looking at the Benefits of Diversification chart, you can see that for the global stock portfolio, 1994–2018, if you remove the top 10% of stocks (according to rate of return), the overall rate of return is reduced by almost 60%. In other words, the top 10% of stocks generated almost 60% of the total return. The point here is that you are more likely to pick a stock that will underperform than you are to pick one that outperforms the market.
Concentrating your portfolio in a few stocks rather than holding a properly diversified portfolio would be akin to Joe concluding that he can increase his compensation from his football contract (his expected rate of return) by playing football without a helmet (increasing his risk of injury). Your risk of lower performance is increased while your expected rate of return is unchanged.
Explore the world
In addition to the risk of concentrating in too few stocks, you must be aware of the risk of concentrating in one asset class. Because we live in Canada and spend our loonies here, as investors we have a bias toward investing in Canadian securities. Many investment portfolios we see have a home bias – that is, a large percentage of the equities are Canadian. Canada represents approximately 3% of the world’s market capitalization, which means if your investments are concentrated in Canadian securities, you are literally missing a world of opportunities. Looking at the Practise Smart Diversification chart, you can see that a portfolio invested 100% in the Canadian stock market could reduce its volatility by over 2.5 percentage points simply by diversifying with US and international stocks.
Diversification is not defined by how many stocks or funds you own. A diversified portfolio should be structured to hold multiple asset classes that represent different market dimensions across the world. Perhaps brilliant Noble Laureate Merton Miller, after a distinguished career studying financial markets, said it best: “The only thing we know for certain about investing is that diversification is your buddy.”
Find a trusted coach
Thankfully for Joe, his coach is also a seasoned investor who works with a qualified financial professional. After hearing what Joe was about to do with his investments, Coach introduced him to his advisor, who educated Joe on owning a globally diversified portfolio – and always remembering to wear his helmet.
First published in the March 2020 edition of The Business Advisor.