Here’s a classic lesson in how not to invest
A well-diversified portfolio spreads assets over a range of securities to reduce risk
I received an email from a reader the other day that made my blood boil.
I won’t name her to protect her privacy and save her embarrassment, but this is part of what she wrote:
“Seven years ago my adviser had me put my entire portfolio into XCS (an iShares Canadian small-cap ETF that trades on the TSX). Before Trump got elected I sold half of it at a $20,000 loss because I decided that if things got even worse that at least I’d have some money left. (It’s meant to help cover health and dental for what will likely be my last 20 years on the planet.)
“The shares I still have in this fund have never recovered and I’m still down $20,000. I’m writing to ask: if you held this fund (which I realize, of course, you never would!) would you sell the remaining shares and take another $20,000 loss? I realize that no one has a crystal ball but I know that things could get a lot worse and I’m scared because this ETF could fall even further. It’s currently holding 28 per cent materials and 23 per cent energy.
“I know now that it was crazy to put everything in one fund but my adviser kept claiming that, because it’s an ETF, it’s diversified.”
This is a heartbreaking story — all the more so because the adviser who told her to invest everything in a single fund had to know it was a bad idea.
No one should ever put all their fi- nancial eggs in one basket, no matter how attractive it seems. Odds are it will end badly.
The adviser used the excuse that the ETF is diversified because it invests in a number of stocks — 206, to be exact, according to the iShares Canada website.
But the number of shares in a fund doesn’t mean it’s truly diversified. In this case, all the stocks are small- to mid-cap Canadian companies.
You won’t find any big banks or hightech giants here. The largest holdings are firms like MEG Energy, Gran Tierra Energy, First Majestic Silver, Interfor Corp. and Nuvista Energy. These stocks have all done well lately, but overall this ETF was showing a small loss for the year as of the time of writing.
Any adviser who would claim that a small-cap ETF represents a diversified portfolio knows nothing about what the word means.
And, with apologies to the woman who suffered through all this, neither did she when she agreed to go ahead.
Investopedia defines the word in this way: “Diversification is a means of managing risk, and it is accomplished by mixing a variety of financial instruments within a single portfolio. The goal of diversification is to minimize the impact that the performance of any one security will have on the overall performance of the whole portfolio. As such, diversification lowers the risk associated with the portfolio.”
Clearly, investing every penny you have in a small-cap fund doesn’t meet this standard. It’s not hard to put together a well-diversified portfolio that will achieve the goals of spreading your assets over a broad range of securities and reducing risk. In fact, investing in just five securities could do it. Here’s what to include. You can use either mutual funds or ETFs.
A Canadian universal bond fund: Choose one that covers both the government and corporate bond markets. Most major fund and ETF companies offer them.
Aglobal bond fund: Don’t confine your bond holdings to Canada. There are often better returns available in other parts of the world.
Abroadly based Canadian stock fund: Forget about sector funds. Choose a fund that covers the entire Canadi- an market — ideally including stocks of all capitalizations, small, medium and large.
AU.S. equity fund: Again, look for one that covers the broad market. Don’t confine yourself to one-index funds, such as those based on the S&P 500 or the Dow. Some of the biggest gains this year have been in high-tech stocks listed on Nasdaq; don’t choose a fund that excludes those.
An EAFE fund: Finally, you want some exposure to overseas markets. EAFE stands for Europe, Australasia and the Far East. Such a fund will provide all the geographic diversification you need.
The percentage allocation to each fund will vary with your age and risk tolerance. Investors who are at or near retirement or who are very conservative should put a larger percentage of their money into the bond funds. Younger people with a longtime horizon should focus more on stocks, although some caution is indicated right now, as markets are expensive.
As for our reader who wants to know what to do now, she should find a new adviser who will help her totally revamp her portfolio so it is properly diversified. Yes, that means taking another loss, which is hard to swallow. But the alternative is to maintain her high-risk, one-dimensional investment and risk being hit even harder in the future.