Most investors recognize that you need to diversify among a variety of industries and companies. But to work its magic, diversification also requires balance.
The goal of diversification, of course, is to reduce risk. Most investors know this, but they give less thought to the role that portfolio balancing plays in achieving the right kind of diversification for their objectives and investment temperament.
Too little exposure to one type of investment renders its potential impact meaningless; too much of any one kind of asset not only over-exposes you to that asset’s own peculiar type of risk, but also crowds out other investments.
Balance all your risk
It pays to keep balance in mind with all your assets, not just your stocks. For example, whatever ‘liquid reserve’ you set aside for emergencies, in a high-interest savings account or whatever, should be a meaningful amount. You want a large enough liquid reserve that you can weather a business downturn or job loss without having to sell stocks or other assets at distress prices.
Many advisors feel six months of after-tax salary is about right as a liquid reserve, by the way. That rule of thumb has been around since at least the 1950s, and possibly much longer.
One hard-to-balance area is the family home. It is apt to represent a lopsided proportion of your total assets. However, a home serves a variety of purposes: It provides you with a place to live, long-term capital-gains potential, collateral if you need to borrow, plus a hedge against inflation. For many investors, it is not only permissible but unavoidable that your home equity makes up a disturbingly large portion of your net worth.
In all aspects of your finances, you need to rely on your own judgment to figure out the right proportions. You’ll need to consider your circumstances, age, risk tolerance, income and so on.
The key investment decision you have to make is how much of your portfolio you’ll allocate to interest-bearing obligations (apart from your liquid reserves), and how much to stocks (or other securities you can convert into stocks).
Stocks vs. bonds and GICs
The need or desire to be conservative in your investments plays an important role in this decision. Up to a point, the more conservative an investment balance you’re aiming for, the more interest-paying securities you’ll want in your portfolio. Aggressive investors lean more heavily toward stocks. But here too diversification pays.
A portfolio made up largely of bonds is conservative in a time of stable or falling interest rates, and high ‘real’ interest rates (that is, interest rates that beat the rate of inflation). But to protect against an upsurge in inflation, conservative investors ought to hold both bonds and stocks.
Within the interest-bearing part of your portfolio, you’ll want to balance your maturities—that is, stagger them, so some of your funds come up for reinvestment each year, at prevailing interest rates. We advise you to stick mainly with terms of one year to five years. You may want to skew your holdings toward longer terms when you feel rates are high, and apt to come down; you may want to lean toward shorter maturities when rates seem low and apt to rise. But in all cases, you’ll want a significant portion to mature each year.
That cuts risk you’ll lose money due to the largely unpredictable changes that take place in interest rates over the long term.
You need balance as well as diversification in the common stocks portion of your portfolio, regardless of whether you aim for income, appreciation or a combination of the two. You’ll want to spread out your risks, regardless of whether you see yourself as a trader or long-term investor.
The long-term investor in particular is apt to want some representation in each of the five main sectors of the economy—utilities, finance, consumer products, manufacturing and resources.
Generally speaking, you should invest 15 to 25 per cent of your equity funds in each of the five. You can choose between greater and lesser amounts based on your objectives, industry outlooks, or a combination of the two.
This is an edited version of an article that was originally published for subscribers in the April 2, 2021, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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