Last week we explored the topic of risk and emphasized the importance of finding the right mix of stocks and bonds to meet your needs. Once you have determined your mix, there is another great way to reduce portfolio risk which is to make sure you don’t have too many eggs in one basket. The technical term for this is diversification. Here are several ways to diversify:
1. By Sector
By sector, I mean companies that are categorized by their line of business. The main sectors are listed in the diagram below. As a Portfolio Manager, I like to have stocks in a minimum of five sectors to reduce risk. In fixed income you can diversify by the bond issuer (e.g., government vs corporate) and by the bond rating. Bond ratings are scaled from safest (AAA) to riskiest (C). I don't like to have more than 20% of fixed income or 10% of the portfolio in bonds rated BBB or lower due to their increased risk.
Retrieved from https://www.personalfiguy.com/2019/02/27/stock-sectors-market-slices/
2. By Geography
While Canadians are probably most comfortable buying Canadian-listed stocks, Canada is only 4% of the world market and certainly has less growth potential than a country such as India or China where the population is exploding. And what about our neighbor close to home? For nine of the last ten years, the US market has outperformed the Canadian market. So if you didn’t have US exposure, you missed some excellent growth.
3. By Investment Style
Stocks can generally be divided into two groups - growth stocks and value stocks. Growth stocks typically don't pay a dividend as the company reinvests their earnings to help the stock grow while value stocks often pay a dividend to reward shareholders for owning it. Growth stocks tend to outperform value stocks in a declining interest rate environment which we've had the last few years. Value stocks, meanwhile, tend to perform better in a rising rate environment.
Retrieved from http://www.multibaggers.co.in/value-or-growth-stocks-which-is-better/
4. By Company Size
Companies are typically categorized into three groups - Small, Mid and Large Caps. Caps stands for market capitalization which is a measure of how big they are. Generally speaking, small caps are more volatile, however, they can offer higher returns than large caps. Large caps, on the other hand, can provide good steady returns and dividends.
Another way to reduce risk is to watch your position size. You may be tempted to allocate a huge chunk of money into a position you love but that will definitely increase the risk. As a rule, I don't have more than 10% of the portfolio or 15% of the equity in one position and even that would be a high concentration for me.
Way back in blog #3, I talked about the difference between investing and gambling. We have a tendency when we gamble to want to ‘go all in’,’ ‘take chances,’ and ‘get rich quick.’ When you construct a well-diversified portfolio of stocks, you want to ‘spread the risk out,’ ‘make calculated decisions,’ and ‘get rich slow.’