Smooth out your portfolio

For decades, investment professionals have preached the importance of diversification. It’s an easy enough concept to understand: spread your investments into different countries, sectors or asset types.

A diversified portfolio, with a mix of uncorrelated assets, tends to smooth out performance. At least that’s the theory. In normal markets it’s worked well, but these are not normal times.

Consider the following research on the Canadian and U.S. equity markets. In 2011, JPMorgan found that the 250 biggest stocks on the S&P 500 had a correlation of about 0.81, whereas historically it was 0.3. (A correlation of 1 means two investments move lock step with each other, a correlation of minus 1 means the investments move opposite directions.)

CIBC noted a similar trend in Canada earlier this year. The bank says 15 years ago Canadian stocks had a correlation of about 0.6 to global stocks, today it’s closer to 0.9.

“We certainly are seeing more correlated markets,” says John Nardi, a financial adviser with Edward Jones. “We’ll probably turn the corner at some point, where (equity) markets become less correlated again, but I don’t know when that will happen.”

While the broad markets have been moving in sync, some sectors continue to move in opposite directions. The S&P/TSX Capped Energy Index, for instance, is down 4% year-to-date, while the S&P 500 Information Technology index is up 16.7%. “Diversification will still smooth out the ride,” Nardi says. “You’ll always be participating in one or two sectors that are doing well at any given time.”

Equity diversification is especially important for Canadian investors since the market is small and concentrated in a few industries. Financial, energy and materials stocks make up about three-quarters of the S&P/TSX Composite. By comparison, the top three sectors on the S&P 500 (financials, telecom and consumer discretionary) account for only 60% of that index.

For stock pickers looking to diversify their holdings, Nardi suggests buying at least two companies in all of the 10 main industries in Canada. “If you want to get more aggressive add a bank from the States.”

If you are a mutual fund or ETF investor you should consider holding between four and six funds, says Cory Papineau, a senior financial adviser with Winnipeg’s Assiniboine Credit Union. Papineau recommends building a portfolio that includes one U.S. equity fund, a global equity fund with exposure to developed and developing countries, a Canadian equity fund and two bond funds, one that focuses on Canadian bonds and the other global fixed income. People don’t need to buy sector-specific funds, he says, since most ETFs and mutual funds tend to own companies across a variety of sectors.

As for assets, Papineau says the general rule of weighting a portfolio, 50% Canadian, 25% U.S. and 25% international is a good starting point. While the 50% weighting in Canada may seem high given the concentration of the market in a few sectors, Canadian investors feel more comfortable buying homegrown funds and limiting their currency risk. But investors wanting to get a little extra growth out of their portfolio could possibly do so by increasing the weighting of U.S. equities, says Papineau.

Of course diversification of equities is only part of the equation. Holding other assets like fixed income is also key to building a diversified portfolio. And like equities, you need to diversify this part of your portfolio too, by holding a mix of government and corporate bonds, with varying levels of risk.

As important as diversification is, it’s possible to have too much of a good thing. You need to be diversified enough for your portfolio to be safe if a particular sector declines, Nardi says, but too much could result in a lifeless portfolio.

To avoid overdoing it, Nardi suggests what he calls the five-10-20 rule: never put more than 5% of your money in one stock, 10% of your assets in a single bond or 20% in one equity fund.

While there will continue to be volatility in the market, most experts believe diversification can balance out the ups and downs. The key, though, is to stay diversified even when it seems like everything is correlated. “You need to commit to owning a diversified portfolio,” says Nardi. “Otherwise you’ll feel all the upsides and be elated in some years, and get the downsides and be deflated in others.”