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INVEST & PROSPER: Risk and Diversification

DIVERSIFY
Not only does diversification, the second golden rule of successful investing, mean never putting too many eggs in a basket that must also be appropriately balanced between fixed income and equities, but the all-important equity section of portfolios must also in turn be divided into sufficient sub-sectors to spread the risk still further among an appropriate number of individual stocks.

With Canada comprising a modest 2-to-3% of global stock market capitalization, it becomes that much more important to consider diversifying internationally, thereby having more and better investment bargains to choose from. Global diversification can be achieved either through investing in international mutual or exchange-traded funds, or indirectly through U.S. and Canadian corporations with a heavy international operating content. In such a search, it will be found that there is no shortage of foreign equities to choose from, confidence in the sources of information on which such decisions are based being key.

The need for diversification also highlights the need for individual portfolio holdings to be statistically meaningful. In other words, not so excessively that individual holdings become too small to contribute meaningfully to overall portfolio growth. Ideally, individual equity holdings should never be less than 5% of an overall portfolio for this reason. In turn, regular re-balancing of holdings to equal dollar weights is essential in delivering the superior longer-term results that this distinctive and proven approach can bring.

By definition, investing can never be without risk – recession, inflation, world calamities, inexorable international competition, changing technology, increased taxes, corporate failure or profit shortfalls, et al. Nevertheless, risks like these can be reduced to manageable proportions by preparatory research, judicious asset allocation and adequate diversification – those golden rules again!

Risk can also be controlled, or hedged against, by the knowledgeable use of sophisticated contractual instruments called derivatives whose value is “derived” from changes in forces impacting on stock and bond prices. For example, a grain farmer will sell a contract to lock in the price of his crop, while a buyer, perhaps a good processor, will buy the derivative from the grain farmer to lock in raw-materials prices. In the final instance, derivatives can be used to insure portfolios against capital and income loss and in so doing be very effective in leveraging, i.e. enhancing, investment results through borrowing. But at the same time they can be disastrous if borrowing to excess, or if they are used recklessly.

CHERRIES ON THE TOP
Balance portfolios correctly, diversify, go about investing in a disciplined, systematic fashion and in due course there could well be enough of a cushion for some higher-risk investing, even speculation for one-shot gain to add to the potential wealth accumulation: But always remembering to investigate first and then only considering such actions once portfolios have been properly set up – and the potential losses of higher risk-reward propositions can be afforded.

A final reminder is of how successful investing, a long-term, risk-reward proposition, must by definition involve the climbing of never-ending walls of worry in an interdependent process of many variables. However, stick to the two golden rules, give it time and discipline, and be confident of that worry-free retirement becoming a reality – through superior and successful investing.

Never forget, too, that in climbing these walls of worry the time spent in the market will be much more important than day-to-day timing. The iconic Sir John Templeton used to contend that the best time to invest was when one had the money. In similar vein, the legendary Warren Buffett has always welcomed uncertainty and the bargain opportunities it brings as the friend of the buyer of long-term investment value.

Notwithstanding the complexity of modern-day investing, our parents never had anything like today’s range of investment products and services to choose from or, on which to plan and build their long-term retirement futures. To invest and prosper, and to successfully ride that risk-reward equation, is an achievable challenge within our grasp as never before. For investors in today’s enviably-positioned, fiscally-sound and attractively “investable” safe and sound place for investment like few others!