Equity Diversification

The main thing I wanted to post about today is investment diversification – particularly that of the Canadian stock market. Rob Carrick wrote an excellent piece in the Globe about this very topic in which he says that three quarters of the TSX is made up of financials, energy and materials whereas sectors like health care and consumer staples which make up 20% of the S&P 500 are woefully under-represented in the TSX with a weighting of only 2%.I think this is very important because although most diy investors understand the concept of diversification, we tend to assume that if you gather enough stocks together in one basket that it will probably be diversified. Products like index funds, ETFs and large mutual funds normally hold hundreds of different securities so it’s hard to imagine that there could be a lack of diversification. Unfortunately investing in the Canadian index is kind of like buying 3 or 4 stocks when you really should be buying 10 or more to be diversified properly over different sectors.

Volatility

The downside of a more concentrated portfolio is higher volatility. We saw that in the late 90’s and early 00’s when Nortel dominated the Canadian index – at one time it represented 35% of the index. Ironically infotech is now one of the sectors which is underweight in the TSX index at 5% compared to 15% in the S&P 500. If you look at a graph of long term TSX returns, you’ll notice a sharp bump around the year 2000, this was mainly because of the tech bubble but I would bet that if you took Nortel out of the index and recalculated the returns around year 2000, you would see a smaller and smoother bump.

International and American equities

What to do about this? The easiest way is to lower your Canadian content and buy more US and international equities. For people who don’t want to lower their Canadian allocation, Carrick suggests buying mutual funds with different allocations than the TSX such as value funds. I would also suggest that with all the new sector ETFs available, it should be possible to buy a broad based Canadian ETF such as XIC or a Canadian index fund and augment with some sector ETFs in order to fill in the gaps. The sector list of the S&P 500 which is listed at the bottom of Carrick’s article is probably a good guide for this.

Other

Thanks to Million Dollar Journey for mentioning my series on leveraged investing in his “bonus” post today. He has inspired me to do an extra post of my own, which is proving difficult so far because one of my typing hands is currently being used to hold onto my young son who is sleeping on my chest. As well, one of cats is sleeping between me and the laptop with her head on the laptop. The “conditions” I have to work in!

First off I wanted to highlight an excellent series on buying and maintaining a rental property written by Financial Security Quest – a young DIYer in Toronto who recently bought an investment condo. Part 7 is particularly amusing and should be required reading for anyone who thinks rental properties are “easy money”.

Ok, the cat moved so typing is a bit easier now.