The importance of diversification

By Bruce Sellery on September 25, 2012
Estimated reading time: 4 minutes

After paying debts and saving cash investing is the next logical step, but Bruce Sellery says don't risk it all a single stock.

Question

I am 33, married, with two small kids. Our emergency fund is solid, the RESP is topped up, and the mortgage is locked in at an ultra-low rate. I have been putting an extra $700 against the mortgage bi-weekly, but I wonder if there is a better way to use these funds. While I do have some unused RRSP contribution room, I have a defined-benefit pension plan so I’m not too worried about it. I am not risk adverse, but have been pretty conservative to date. I also have $10,000 sitting idle in a checking account. My current plan is to buy a single Canadian bank stock in a TFSA, and buy another stock every three months with the accumulated $700 bi-weekly. What would you do in my shoes?

Answer

Gold stars. Gold stars for you. You are doing so many things right when it comes to your money: Saving up in an emergency fund, making the most of the RESP, aggressively paying down your low-rate mortgage. All good. But you are on the verge of making two big and completely avoidable mistakes. For the sake of simplicity, I’m going to assume that investing this extra money in the markets makes sense for you. You don’t need to buy a new car, and you’re not planning a big vacation or home improvement project. You want to use this money to make money. I get it. So here is my opinion on the mistakes you’re about to make, and what to do instead.

Mistake 1: Not diversifying your equity investments

It doesn’t sound like this $10,000 is play money to you. Putting the entire amount on one name—even one as solid as a Canadian bank—exposes you to risk that runs counter to your conservative nature. There are so many questions facing the financial sector, and the banks individually: How will the debt crisis in Europe impact the global economy? Is the housing market in Canada ready to burst? How are the international operations at your bank of choice performing? How does the current stock valuation reflect future earnings? So many questions for the banks and you’re about to place your bet on just one of them? Sure, it might be the best way to win big, but it’s also the best way to lose big. Unless you really are gambling with this money, you need to diversify. For example, you might put a third of the money on a bank stock, and then find a few other investing ideas for the remaining money. Just be sure that those other ideas have different risk factors or you won’t actually be diversifying your risk.

Mistake 1: Underestimating the work involved in investing in stocks

It is easier than ever to figure out the logistics of investing. You can just open up an account at a discount broker and you’re in business. But figuring out the strategy that is going to work for you is more complicated. If I were in your shoes, I wouldn’t buy individual stocks. You are going up against professionals who spend 80 hours a week analyzing financial statements and macro economic indicators. Again, there are more questions: What reinforces your belief that financials will outperform commodities or technology stocks? If now is the right time to buy these stocks, when is the right time to sell? The pros may not always be correct in their answers to these questions, but at least they have thought them through. Investing in individual stocks takes a huge amount of time and with two small children I’m going to guess that you probably don’t have that sort of time.

Investigate exchange-traded funds

You can still get into the stock market in a diversified, low cost way. I recommend you do some research into exchange-traded funds. Rather than buying just one bank stock, you could buy the financial services index, which gives you exposure to all the big names in Canada. You can invest in stocks that make up the S&P 500 or the NASDAQ, by choosing an ETF that mirrors that performance. You still need to do research and have a point of view of where the markets are headed. But you will have some diversification and with much less work that is required to follow individual names. I hope my answer didn’t scare you. I’m a big advocate for people to get more engaged with their money. But you need to figure out the level of complexity that is right for your circumstances. And at this stage of your life it might make more sense for you to put that $10K into a lump sum payment on your mortgage and just be done with it.