Avoid putting all your eggs in one basket
Diversification key strategy for weathering economic cycles, financial advisers say
With the economy’s frequent ups and downs, investing can be daunting. Yet there are ways to ease the anxiety of financial fluctuations. The best advice? Keep calm and carry on.
One of the most important first steps is to examine and understand your full financial picture.
“You want to start by having a thorough and ongoing discussion with an adviser to help assess who you are as an investor,” says Serena Cheng, wealth adviser at Richardson GMP in Toronto.
“Consider your income, debt, cash flow, experience and knowledge of the financial market, your age and time horizon, the number of dependants you support and your ability to emotionally handle the volatility of the market. In order to feel confident about your finances, you need to decide on your goals and where you want to go.” Diversify and conquer When it comes to minimizing risk, most investment advisers agree that diversification is an ideal way to manage your portfolio.
Diversification is simply spreading your investments among a variety of different categories, products and industries. While there are many ways to diversify your portfolio, says David O’Leary, managing partner at Eden Valley Partners in Toronto, “most commonly, investors diversify by splitting their investments over a variety of categories such as stocks, bonds, income trusts, preferred dividend shares and real estate. Stocks can be split over industry sectors, such as energy, banks or pharmaceuticals. You can also break down your investments geographically, with exposure to a variety of both developed and developing markets.”
The notion is simple: don’t put all your eggs in one basket.
“The basic concept is this: we don’t know what the future holds and what types of investments will perform best going forward, so the prudent thing to do is to own a combination of investments,” explains O’Leary.
“If you invest wisely, diversification will reduce the volatility of your portfolio far more than it reduces the return you can expect to achieve.” Assessing the ebb and flow Ideally, you should be looking at investments that ebb and flow at different times based on their past performance.
One simple example is stocks versus bonds. Typically, these markets move in opposite directions, at least in the short term, so it’s safe to say that a combination of the two will minimize portfolio instability. But it goes deeper than that — when it comes to equities, large companies may perform differently than small companies, and value stocks (stocks that are currently priced lower than their fundamental value) often have different cycles than growth stocks (shares in companies that are expected to grow at an above-average rate compared to the overall market).
“What you’re looking for in your portfolio, in an ideal world, is to own investments whose returns have zero correlation,” says O’Leary.
In other words, little or no correlation between when one investment goes up and down compared to another. The result of low correlation over the long term is that you have a variety of investments performing well at different times, eliminating bumps in the road and keeping your portfolio steady.
How diversified should your portfolio be? According to Cheng, “to limit losses, no more than 5 to 10 per cent of your portfolio should be concentrated in any one investable asset.”
A diverse portfolio is best achieved with the help of a financial adviser, who can recommend the best combination of assets to build your wealth with the appropriate amount of risk for your investment style. “And revisit your portfolio regularly together to ensure it’s consistent with your goals,” adds Cheng.