Take a look in your closet and scattered among your favourite jeans and your best suit will be a bunch of items you never wear. You probably have too many T-shirts, pants that don’t fit properly, and shoes you now think are ugly. But you can be forgiven for this, because we all buy our clothes a few items at a time, without much thought to how they fit with what we already own. And so what we end up with is less a well-planned wardrobe and more a collection of random garments.
Unfortunately, many investors use the same haphazard approach. They make impulse purchases, buy whatever is in fashion, and hang onto old favourites with sentimental value. All the while they fail to consider whether that stock, ETF or mutual fund fits into their overall plan. As a result they end up with a disorganized pile of investments rather than a well-built portfolio.
Next time you’re shopping at the investment mall, I encourage you to take a more thoughtful approach. Before adding anything new to your portfolio, ask yourself two questions: first, will adding this security increase my portfolio’s long-term expected return? And if not, will it reduce my risk? If the answer to both questions is no, then don’t buy it.
Let’s work through this thought process by considering an investor who holds all of her money in a savings account. This “portfolio” carries almost no risk of loss, but its expected return is less than the inflation rate. So how can it be improved?
We could start by adding a Canadian equity fund. We know stocks have higher expected returns than cash, so answering our first question is easy. Of course, we also know stocks are volatile and there is some risk of permanent loss, but we accept this as the price we pay for higher returns.
Should we also add U.S. stocks to our portfolio? Recalling our first question, we consider whether we can expect U.S. stocks to deliver higher returns than Canadian ones. Over the long term, we can’t make that argument with any confidence: we should expect their returns to be similar. So we move to our second question: will adding U.S. stocks reduce risk?
The answer is yes—but not because stocks in the U.S. are any less risky than those in Canada. The benefit comes from the added diversification: the U.S. market is much bigger than Canada’s, and it’s less concentrated in commodities and banks. You’ll also get exposure to another currency for an additional layer of diversification. The two markets do not move in lockstep, so over the long term, a portfolio that includes both U.S. and Canadian stocks should be less volatile that one that includes only one or the other.
Adding international stocks improves the portfolio further by reducing the volatility a little more without sacrificing anything in expected return.
In case you think all of this is just theory, I ran the numbers to see whether this really worked in practice—and it did. Between 1970 and 2016, a portfolio of half Canadian and half U.S. stocks showed significantly lower volatility than either of the two countries individually. And a global portfolio with equal amounts of Canadian, U.S. and international equities was even less volatile. What’s more, the reduction in risk did not come at the expense of lower returns: that’s the free lunch of diversification.
This is exciting stuff, I know, but most people can’t stomach the risk of an all-equity portfolio, even one that holds thousands of stocks from around the world. In a major bear market, even global diversification won’t save you from gut-wrenching losses—and that’s why a balanced portfolio needs bonds as well.
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Clearly adding bonds to a portfolio full of equities doesn’t satisfy our first criterion: a broadly diversified bond fund yields about 2.5% these days, which is a lot less than we would expect from stocks. But they clearly meet our second condition by reducing the risk of steep losses: high-quality government bonds offer significant protection during a market downturn. And so we accept a lower expected return in exchange for a much smoother ride.
All of this may seem like common sense, but based on the portfolios I’ve seen, it’s not common at all. Many investors start with the fundamental building blocks, such as well diversified index funds and ETFs in the major asset classes. But they can’t resist adding a couple of individual stocks or a gimmicky ETFs with a clever-sounding strategy. Over the years they end up with a closet full of two-tone shoes, purple hats and Hawaiian shirts that serve no purpose other than to add cost and clutter. If your portfolio looks like that, apply our two-question test to each security—and then take out the trash.