Understanding Investment Diversification

No, Iʼm not talking about the time the TV show Friends added an African-American woman to their cast… Iʼm talking about diversification in your investment portfolio.

What is diversification?

I feel there is a lot of misunderstanding about what investment diversification is and how it can protect your money when it comes to investing. The concept goes that if you have your eggs in several different baskets, you arenʼt as exposed to losses that may occur in one business, or one sector of the economy.

Letʼs look back at Nortel Networks as an example. This stock was all the rage back in the 90ʼs (just like Ross and Rachel) and people couldnʼt buy enough of it. At one point Nortel accounted for more than a third of the total valuation of all the companies listed on the Toronto Stock Exchange.

People started selling their other stocks and buying more Nortel shares. Even pension funds (which shouldnʼt be risking anyoneʼs retirement money) were heavily invested. To make matters worse, many people were buying the stock on margin, or using leverage to buy shares with borrowed money.

When the dot-com bubble burst, Nortel Networks stock fell from $124 a share in the year 2000 to $0.47 a share by 2002. The company filed for bankruptcy shortly after that.

So why did all these otherwise smart Canadians put all their eggs in one basket? Fear and greed. Fear of missing out on a great investment and greed for not taking some of their profits and diversifying into other types of investments when they had the chance.

Would it surprise you to know that 70% of Canadians today are highly leveraged and have hundreds of thousands of dollars invested in one single asset class.Many using 95% borrowed money?

Thatʼs right, a record 70% of Canadians now own real estate. Even though home prices have never been higher, people are lining up to invest in real estate the same way people did for Nortel at itʼs peak. By the way, American home ownership peaked at 69% right before the bubble burst.
Our own government is so scared by this lack of diversification that they brought insweeping changes last week to try and cool down the real estate market.

Donʼt get me wrong, I think investing in real estate is great. What I donʼt think is great is ONLY investing in real estate. Or having the majority of your net worth in a single stock.

Right now there are young people taking all the money out of their RRSP to put 5% down on a $300k condo in Torontoʼs over-built condo market. Most of them are trading in mutual funds that hold a diverse basket of stocks and bonds to buy a condo that wonʼt be built for a year or two. They are trading in the safety of a diversified stock portfolio that they own, to make a risky $300k leveraged bet on a single stock.

Think of all the people in the States who took out home equity loans when the value of their houses went up. Many of them used that money to do home renovations and put in a fancier kitchen or new bathroom. They took the profits from their real estate investment and used it to invest in… more real estate! When home prices dropped by 50%, no one cared that the house had a new kitchen, you couldnʼt sell it anyways.

If you have the majority of your net worth in your homeʼs equity and are wondering about the future of real estate in Canada, or how one would go about diversifying, I highly recommend that you read Garth Turnerʼs blog.

If you are just starting out as an investor and are wondering if there is a low cost, safe way to build a diverse investment portfolio, I suggest you look into starting a couch potato portfolio as recommended by Money Sense magazine.

Here you will learn how to build a diverse portfolio that includes:

  • Canadian stocks 20%
  • US stocks 15%
  • International stocks 15%
  • Real estate 10%
  • Bonds 40%

Since you never want to have more than 10% of your investments in a single industry, the 10% in real estate is good asset allocation.

This 10% will be split between real estate investment trusts that invest not only in rental apartments, but also shopping malls.

So even in one industry, you are getting further diversification!Well, I hope this gets your wheels turning and gets you thinking about Investment diversification.

Thanks to Mr. CBB for letting me hang out!


Photo Credits:Copyright (c) 123RF photos

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