Economist and Nobel Memorial Prize winner Harry Markowitz once said that diversification is the only free lunch in finance. In other words, diversification can reduce risk and volatility with no cost or reduction in returns.
That is not to say that someone may not get lucky by buying a single stock or having a large part of their investment portfolio in one investment. It is just that the odds of investing successfully increase by diversifying.
Most academic research suggests at least 10 stocks are required to achieve diversification, with some suggesting up to 40 stocks or more. What this means is that by adding an additional holding, the incremental diversification is small.
Exchange-traded funds (ETFs) generally have even more holdings. The largest Canadian ETF by assets under management (AUM), iShares S&P/TSX 60 Index ETF (XIU), tracks 60 stocks. The largest ETF in the world by AUM, SPDR S&P 500 Trust ETF (SPY), tracks 500 stocks.
Some do-it-yourself investors hold concentrated portfolios of stocks because they only buy a few holdings and simply fail to diversify. If you are going to be a DIY investor, you should either commit to doing the research required to build and maintain a diversified portfolio, which can be difficult, or opt for the simplicity of ETFs.
Some employees have non-registered savings plans at work where their employer matches their purchases of company shares. Taking advantage of employer matching contributions is like getting free money, so employees should probably maximize their contributions to the extent they can do so. In order to avoid overexposure to a single stock, consider selling shares periodically based on the terms of the savings plan. Employees can often sell shares after one year, and in some cases, at any time without restriction.
The proceeds can be reinvested into a more diversified portfolio. Sometimes, the proceeds are better directed towards debt repayment, Registered Retirement Savings Plan (RRSP) contributions, or Tax-Free Savings Account (TFSA) contributions. If the savings plan is a registered one, like an RRSP* or Defined Contribution (DC) pension plan, consider whether there are other investment options in the plan beyond company shares.
It may seem more comfortable to invest in something you know—like shares of your employer—than other investment options. But remember, not only the success of your shares is tied to the performance of your employer, but even your bonus or your job itself could be at risk if the company goes through tough times. If you did not work at that company, would you have bought those shares in the first place?
Employees who are granted stock options are most likely to end up with an overexposure to an employer’s stock. Companies want their senior executives to be aligned with the success of the company.
Another consideration with stock options is to try to avoid getting painted into a corner. Most stock options have a 10-year expiration, meaning you can delay exercising the stock options and selling the shares for up to 10 years. It is important to remember, especially now, late in a bull market, that stock markets can have negative three-year and even five-year returns. The likelihood of an individual stock having an extended period of poor performance is higher than that of a diversified stock market.
If an employee has significant stock options within a few years of expiration, they should consider exercising options in stages rather than waiting right until expiry.
If someone has a significant holding in a single stock, they should consider having the rest of their portfolio underexposed to that sector. In other words, a bank employee with stock options may want to consider having an underexposure within their investment portfolio to the financial sector.
Investors with high exposure to a single stock often worry about the deferred capital gains and resulting tax if the holding is in a non-registered account. Tax is always a consideration, but should arguably be secondary. Tax may just be the price you pay to diversify, reduce risk, and potentially increase future returns. Tax can also be mitigated by making RRSP* contributions or using other techniques like spreading the sale out over multiple years.
More elaborate techniques may also be available, like equity collars. This is an option strategy that involves simultaneously buying a put option as protection against downside risk and writing (selling) a covered call option to finance the purchase of the put. The concept goes beyond the scope of this column, but basically a collar is a method to protect against a stock’s price falling that also involves giving up some upside growth. An equity collar alone does not help diversify, but for large enough holdings, banks may allow an investor to borrow against the shares, albeit at a high financing cost.
Donating non-registered shares with deferred capital gains can be an excellent strategy for those with philanthropic intentions. Not only will a charity issue a donation receipt, but the capital gain inclusion rate will be 0%, meaning no capital gains tax.
Anyone who has a single stock that makes up more than 5% to 10% of their investment portfolio should be considering if they are overexposed and how to best diversify. Diversification is a key to successful investing over the long term.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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