The following post is by staff writer Teacher Man, who writes at My University Money.
The financial industry makes a mint of throwing buzzwords as people that are financially illiterate. How many times do we see financial planners throw around the term “diversification” as if it were not merely one of the Ten Commandments, but first on the list? Diversification is definitely important, but if you’re not really sure what it means, it can be used to justify selling almost anything.
“Hey, does your portfolio include any emerging markets? Better grab this mutual fund for international diversification.”
“The Canadian market is hot this year, we’ve got a 5-star fund to cover the entire sector and it makes sure you’re well-diversified.”
“I would recommend you diversify your holdings with a fund that focuses on growth stocks.”
Sound familiar? That’s because most mutual fund salesman financial planners get paid a commission to sell certain mutual funds regardless of what is already in someone’s portfolio. Often, people who have been saving for years and “buying RRSPs” (a pet peeve of mine is when people say they are going to buy a RRSP… It’s not a financial product people, the P stands for plan) from the same company every year. When you look at what their money is actually invested in, they are inevitably buying the same companies over and over again under different mutual funds and recommendations.
A Kernel of Truth
Diversification is important if you are picking single stocks. This is where the “common sense knowledge” comes from. You obviously don’t want to “Put all your eggs in one basket.” Don’t invest in only mining companies, or go all in on a certain technology stock for example. Where most people should look at diversifying, is actually in the department of asset allocation. Once you decide the amount of your investments that you want tied up in equities, the rest should be pretty straightforward. If you’re a young investor, getting into a mutual fund that is 60% bonds is probably not in your best interest in terms of investing time horizon. If you’re approaching retirement and have a low risk tolerance, being convinced to go with a 100% growth equities fund is probably not a good idea. Once you talk to a fee-only planner and determine your asset allocation, the actual exposure to equities is actually very easy to take care of, and it doesn’t cost a lot of money to meet the magical standard of “being sufficiently diversified.”
Buy American? What Does That Even Mean Anymore?
When you actually look at the makeup of international conglomerates today, the whole idea of needing a lot of stocks is almost a joke. There are holding companies out there such as Power Corp for Canadians, or the famous Berkshire Hathaway of Warren Buffett, that allow you to efficiently invest in companies from a broad range of sectors, that sell products all over the planet. Companies like Coca-Cola, Johnson and Johnson, or the Royal Bank of Canada have holdings all over the world, and are so geographically diversified that an issue in one part of the world barely dents their overall financial position. Most buy-and-hold investors that I follow often find that between 20-30 stocks (and sometimes as few as 8-10) are easily enough diversification to suit their tastes. After all, why do you need 5 gold companies if they all depend on the price of gold anyway?
I have little faith in my personal ability to pick the right individual stocks. For this reason, I am definitely a fan of ETF investing. It is the easiest way to diversify your holdings quickly and efficiently. One interesting thing that I have seen lately, is that even so-called advocates of ETF investing can over diversify. I think that 5-7 ETFs should be the absolute maximum that you need in order to effectively track the world’s stock markets. I’ve seen people that jump on every new ETF that comes out, and doing this merely makes their finances more complicated, and less efficient if one is paying a higher MER than they have to be.
To be brutally honest, investors that merely focus on making smart financial decisions, properly determine their asset allocation, and just buy an ETF like the Vanguard S&P 500 ETF (VOO) over and over again, will probably do better than 90%+ of investors out there. When you really consider that those 500 massive companies that make up the index are really only American companies in the sense that, that is where their headquarters are, then it becomes pretty apparent most investors would be fine just keeping it simple a broad-based ETF such as that one. As a bonus, it costs almost nothing to own (an MER of .06%) and many brokerages are beginning to offer commission-free ETFs at this point as well, which makes it even more cost-efficient.
Don’t try to outsmart yourself this investment season. Take a look at what your portfolio is really trying to accomplish, determine if it’s geared toward your investment goals, and then decided just how much you should be willing to pay for the “magic” of diversification.