Our series of 25 years of lifetime financial lessons continues with a closer look at what makes for a well-built investment portfolio, structured to advance your financial goals.
Balance remains an operative word here, as it was in our previous piece on financial balance. Financial balance is about establishing who you are: Are you comfortable taking financial risks or more conservative? Are you frugal with your money or do you live life large? Portfolio balance is about making sure your investments reflect your personality and strengthen your ability to live the life you choose.
Good Balance Means Good Diversification
If you think of your portfolio as a project, your investments are the supplies you’ll depend on to build it. For example, to build a house, you need solid lumber. You also want nails to hold everything together, shingles for protection, glass for perspective, and concrete for a strong foundation. Each of these components is ideal for some tasks, a poor choice for others, and collectively essential to the whole.
The same goes for your portfolio. Here, having a balance of varied investments is called diversification. By applying effective diversification in and across your portfolio, each part can contribute to your total wealth by fulfilling its ideal role, without having to fill in where it is not a good fit. There are other advantages to diversification, which we’ll get to in a moment.
Building for Portfolio Balance
Early in my career, I learned about the benefits of building balanced portfolios from a mentor and colleague, Michael Nairne. Since then, my appreciation for the power of diversification has only grown stronger, as has my understanding of how to effectively apply it in capital markets. Today, we typically suggest building balanced portfolios from the following broad asset classes:
- Stocks (Canadian, U.S. international and emerging market equity mutual funds)
- Fixed income (domestic and global bonds and bond funds)
- Real estate (as REITs, for flexible liquidity and additional diversification benefits)
Earlier, we used to also invest in tangible assets like oil, gas and gold. Additional research has helped me understand that these are mostly already covered by tilting toward Canadian stocks in our resource-laden country. Because stocks are usually available as more cost-effective and efficiently managed investments, we’ve eliminated tangible asset holdings from our portfolios, to avoid unnecessary, duplicate exposure to this relatively volatile asset class.
A common misperception I often see is that all you have to do to diversify your portfolio is to hold a lot of investments. While this is a good start, it’s not enough. True diversification calls for efficient, low-cost exposure to a large number as well as a large variety of holdings from around the globe. There are at least a couple of reasons for this.
More Consistent Coverage
First, you want to minimize the times when all of your investments are moving in the same direction at the same time. The Crazy Quilt Chart is a classic illustration of this concept. After viewing a color-coded layout of which market factors have been the winners and losers in past years, it’s easy to see there is no discernible pattern. If you can predict how each column of best and worst performers will stack up in years to come, your psychic powers are greater than mine.
Instead of trying to predict future market moves and pile into concentrated positions, we build a blanket of coverage for capturing market returns where and when they occur. This helps replace the guesswork with a coherent, cost-effective strategy for managing desired outcomes.
Finding Your Balance
Diversification also lends itself to maintaining a more balanced approach to investing. If we compare effective diversification to the familiar adage about not putting all your eggs in one basket, your portfolio may hold a lot of securities, or eggs. But it can still be overly concentrated in the undiversified equivalent of many basketful of plain, white eggs, rather than in a varied diet of protein, fruits, vegetables, grains, dairy and more. Over-exposure to just one ingredient in your financial diet is not only unappetizing, it can be detrimental to your financial health. Lack of diversification:
- Increases your vulnerability to specific, avoidable risks
- Creates a bumpier, less reliable overall investment experience
- Makes you more susceptible to second-guessing your investment decisions.
In short, diversification can bring balance to your portfolio and your financial resolve. What’s not to like about that?