Diversification is a relatively new concept on the financial landscape. As equity markets move up and people make money, the perceived need for risk management seems to gradually fall out of favour, only to be rekindled as portfolio losses mount during downward markets.

Diversification as a strategy gained prominence during the 1973-74 bear market when investors lost upwards of 60% of their capital. Until then, the only relevant statistic was the return. Investors had little or no regard for the level of risk assumed to achieve that return. Having suffered such huge losses, investors started to embrace risk management as a cornerstone of portfolio management.

Where is the risk?

The attraction of equity markets stems from the ability to generate returns that are greater than simply investing your money in Treasury bills. Stock markets have returned an average of about 9% per year over the last 90 years or so – but unlike Treasury bill returns, stock market returns are volatile.

Too often, investor expectations are too high compared to the reality of historic returns. When we ask investors their market return expectations, the response is typically "about 15 % per year" - almost 100% greater than the average of the last 90 years. We would argue that this kind of return is only possible if one is willing to accept an extreme amount of risk.

Why not just choose one stock?

If you can make such great returns in the stock market, then why not invest all of your money in one stock? Most of us realize that investing in a single stock is extremely risky because just as that stock may increase in value, so too could it decline. Clearly, a one stock portfolio doesn't work.

A portfolio of roughly 40 names would accommodate diligent in-depth research on each of those holdings. In such a portfolio, risk is managed by ensuring that the investments are in different industries and countries. This diversification reduces the vulnerability of this portfolio of investments to any single macroeconomic shock or random event. The key point is that each stock is expected to do well, but its performance is as independent as possible from the other investments in the portfolio. It is this independence or non-correlation that reduces the risk of the overall portfolio.

What’s wrong with investing only in the TSX?

To understand why it is important to have diversified investments, consider an investor who has created a portfolio of 15 different oil stocks. An investor has limited their exposure to the failure of any single oil company - due to bad management, poor property development etc. However, the entire portfolio is influenced by the price of oil. If the price of oil declines, the portfolio loses significant value.

Let's extend this example further. Suppose that in addition to the above holdings the investor adds another 15 different financial stocks. Once again, the investor has limited exposure to any single financial entity but is still at risk to the financial industry on the whole.

If you add the two portfolios together you get 30 different stocks. Based purely on the number of stocks, it certainly looks like a diversified portfolio. However, the question that must be addressed is "How risky is it?"

It isn't quite as risky as each of the sector-specific portfolios on their own, but it is a giant bet on oil and financials. This means wonderful returns if both sectors do well, and large losses if both sectors do poorly. For most people, this two-sector bet is a little too risky for their nest egg.

However, this above-described two-sector combination is Canada's TSX index. Fortunately for TSX index investors, both oil and financials have done well in the past few years. But the issue is this: How long can this concentrated portfolio continue to run? In other words, how certain can you be that this abnormally positive pattern of returns will continue?

The TSX was never meant to be confused with a well-diversified portfolio. It is just supposed to provide information on the general tone of the market and provide aggregated stock pricing information. Make no mistake, an investment in the TSX or with a manager that mirrors the TSX weightings is a bet on just two sectors. If either sector does poorly, significant portfolio losses will ensue.

Unfortunately, all global indexes have been elevated to the status of portfolios. With the NASDAQ, a mere five technology stocks account for 20% of the weight of the index!

The effect of random events

Random events impact markets at unexpected times and in surprising ways. For example, they can be as dramatic as the terrorist attacks of September 11, 2001, the SARS outbreak or Hurricane Katrina. Or they may be as subtle as a miscalculation of inflation, revision of employment data or a change in the tax legislation. The timing and nature of these events are unknown, as is their potential impact on the market.

The problem with having an investment strategy that is overly concentrated is that a single random event can quickly devastate the entire portfolio. But it seems that the (temporary) absence of such a random event emboldens people to further concentrate their fortune in this risky manner. They fall prey to confusing a lucky run with investment skill.

Random event protection can be incorporated into portfolios by investing in companies that have no relation to each other, are impacted by different macroeconomic factors and operate in different business segments.

By judiciously selecting a portfolio of equities, an investor can be assured that one large random event will not wipe out their portfolio – or cause it to rise spectacularly. Some of the stocks directly impacted in the portfolio will rise spectacularly, but the overall portfolio will not increase at the same rate. For example, a portfolio of all oil stocks will be more sensitive to oil price fluctuations than a portfolio with only one or two energy stocks.

At Toron, we spend a great deal of time understanding the risks that are assumed when making an investment in a particular corporation and also the interplay of those risks with other investments (and risks) in the portfolio. We try to ensure that any single event will not have a big impact on any of our clients' portfolios.

Diversification by country

To truly manage one's risk, the portfolio should be a shock absorber for an investor's activities, not an accelerant. The industry that generates one's income should not be the dominant investment in one's portfolio. This approach may work for a sustained period, but when it goes wrong, the results can be devastating.

The long-term fortunes of businesses and employees in Canada are tied to the fortunes of the country. For the past few years, Canada has done very well. However, a few years ago, the potential bankruptcy of Canada was a legitimate concern.

When investing for the long-term, the supremacy, or decline, of any country can't be assumed. An allowance must be made for the fortunes of one country to surprise one way or the other. The best position to be in is one in which you don't really care, because your investments are diversified globally.

The big secret to investment success

The secret to investment success over the long haul is to not solely focus on returns. An equal, if not greater, emphasis should be placed on risk control. Prudent risk management limits the downside and allows time and compounding to safely work their magic on a portfolio.