The advantages of diversified portfolio holdings include a balance of sectors and risk levels, regardless of your investing temperament

Portfolio diversification is the process of making sure you balance your investments so they are not tied to one industry, geographic area, or investment type. One of the advantages of diversified portfolio holdings is the opportunity for more safety and profit in your portfolio. That’s why it’s a key part of our three-part Successful Investor philosophy.

All in all, you will improve your chances of making money over long periods, no matter what happens in the market, if you diversify your holdings across most if not all of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities.

The advantages of diversified portfolio holdings in regards to risk

Balance aggressive and conservative investments in your Successful Investor portfolio, in line with your investment objectives and risk tolerance. Above all, avoid the urge to become more aggressive as prices rise and more conservative as prices fall.

We believe you should develop a clear idea of how much risk you are willing to accept, through good times and bad. For example, some investors become more aggressive as the market rises and more conservative as the market falls. The problem here is that all market trends, up or down, eventually reach a turning point. If you take on more risk as the market rises, you’ll wind up owning your riskiest portfolio just when the market is near a peak. That’s when risky stocks can do their greatest harm to your net worth.

Furthermore, a balanced Successful Investor portfolio should include a mix of growth and value stocks, big and small stocks, and so on.

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Advantages of diversified portfolio holdings in relation to the five main economic sectors

You should know that the Canadian Finance and Utilities sectors generally involve below-average risk. Manufacturing and Resources tend to be riskier, and the Consumer sector is in the middle.

Consumer sector stocks benefit from continuous, habitual use and have a steady core of sales, regardless of the economy and business cycles. These companies typically make products like soap or soup.

Stocks in the Consumer sector typically provide the most effective protection against economic downturns. That’s a key difference between Consumer stocks and companies in the Manufacturing & Industry or Resource sectors, which are far more sensitive to the ups and downs of the economic cycle.

As a general rule, resource stocks provide the most effective hedge against inflation because they directly gain from rising prices of the commodities they produce. Utility stocks used to provide a hedge of sorts against recessions, due to their steady earnings and dividends. However, that is less true today because of changing technology and deregulation in the utility sector.

However, although it pays to be aware of these general tendencies, you should resist the temptation to fine-tune your portfolio according to theories or predictions about inflation and economic downturns. No one has ever consistently predicted either one—neither in timing nor in degree—so most investors will want to include stocks from most if not all of the five economic sectors in a well-balanced portfolio.

Advantages of diversified portfolio holdings include geographic balance

One of the worst things you can do is invest so that your portfolio would suffer greatly due to a localized downturn in any one city, state or province. Ideally, your portfolio should give you exposure to much of the North American economy, plus substantial international exposure, if only through North American multinationals.

For decades, we’ve advised Canadian investors to spread their holdings out geographically between Canadian and U.S. stocks. Our view is that virtually all Canadian investors should have, say, 20% to 30% of their portfolios in U.S. stocks, with the remainder primarily in Canadian stocks. That can provide all the international diversification you need.

If you want to add more foreign content, you could buy individual stocks on overseas markets outside the U.S. But for most investors, directly investing in foreign stocks can add an extra layer of risk and expense. As well, timely and accurate information about overseas companies is not always available, and securities regulations vary widely between countries. It can also be hard for your broker to buy shares on foreign markets without paying a premium. Tax rules and restrictions on transferring funds between nations add further uncertainty and cost.

Use our three-part Successful Investor approach while building a diversified portfolio

 Investors should never have all their money tied to one investment idea, location, industry or type. When it comes to building an investment strategy, don’t let sound bites and vague predictions warp your stock-trading decisions. Instead, minimize your portfolio risk by following our three-part Successful Investor approach:

• Invest mainly in well-established companies;
• Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; Utilities);
• Downplay or avoid stocks in the broker/media limelight.

What factors do you look at while considering your portfolio’s diversification?

How much international diversification is in your portfolio?