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The Letter D – Diversification: an Investors only Free Lunch.

D – representing the free lunch for investors, which is diversification.  Perhaps the most important letter represented in the ‘investing ABCs’ and thus the longer post and Titanic analogy following.

 

In Canada, diversification is generally thought to be represented by an appropriate mix of cash, bonds and stocks.  Also known as the 60/40 portfolio, as measured by 60% in stocks, 40% in bonds.

 

This Canada-centric approach is slowly advancing towards a more ‘real-world’ approach to diversification, which is more readily practiced in the US, Europe and by larger and more sophisticated institutions in Canada and globally.  And which is the approach that we take with our clients in building sustainable and practical investment portfolios.

 

Real-world portfolio diversification may include cash, bonds and stocks, however is supported and made more effective by the inclusion of one or more of the following asset classes,

  • Real assets including property, and/or timber, resources, infrastructure, etc
  • Private yield/income, from highly collateralized and secured lending arrangements which are exempt of market risks and are exempt of inflation concerns
  • Private equity, which is exempt from market volatility and is included for strong returns despite giving up minute by minute liquidity
  • Absolute return strategies that opportunistically profit in the bond and/or equity markets, and which have access to a larger suite of tools in managing risks and returns.  These strategies aim for positive returns regardless of market direction.

In practice, diversification is meaningful and is the only free-lunch available if applied correctly.  Individual strategies each with their own means to growing in value and each with their own ability to manage risk make for effective diversification when properly combined into one portfolio.

 

In the real-world, if the builders of the Titanic had applied the investment world’s approach to diversification when designing and constructing the ship, it may not have sunk upon hitting the iceberg.  The design of the hull of the Titanic included 16 compartments that were felt to be adequate in order to withstand a breach in one or even more than one compartment.  However, each compartment was not completely sealed off from one another and thus as one flooded the other compartments began to flood as well all due to the same unanticipated problem in hitting the one iceberg.

 

Appling this to your portfolio – in the event of a crisis, how do each of your asset classes and/or investments react?  If some fall, and some remain whole than you are fairly diversified.  If some fall, some decline and some gain in value, then you are more effectively diversified.

 

What does diversification look like in your portfolio in the event of an iceberg?  Is it diversified in name only, and thus all of your stocks and bonds rise and fall in unison?  Or are your compartmentalized assets insulated from one another?  Aim for the latter, and recall 2008/09 and other periods of crisis for a reminder on why to avoid the risks of the former.

 

 

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