Diversification

When equity markets rise and people make money, the “perceived” need to manage risk diminishes, only to return when markets decline.

Diversification gained prominence during the 1973–74 bear market when investors lost upwards of 60% of their capital. Until then, investors focused only on return with little regard for the risk assumed to achieve it. Huge losses caused investors to embrace risk management as a critical part of investment management.

What is the Risk?

Investor expectations often exceed the reality of historic returns. Investors typically tell us they expect “about 12% per year.” Stock markets have returned an average of 9% per year over the last 90 years. Expectations are usually optimistic. Investors cannot reach their expectations without managing risk.

Equity markets can generate better returns than investing in short-term deposits, but equity market returns are volatile so we must employ stringent diversification strategies to even out volatility and meet investor expectation.

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Why Not Just Choose 1 Stock?

Investing in a single stock is extremely risky because its value could increase, but could also decline. Each stock is expected to do well, but reducing correlation between each stock reduces overall risk:

  • Holding a portfolio of about 40 stocks diversifies risk
  • Diversifying the 40 stocks in different industries and countries reduces the risk that any single macroeconomic or random event will pull all stocks down
  • To manage risk, Toron diversifies at the stock, sector and market levels

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Why Invest Beyond the TSX?

  • Canadian stock market is overweighted in financial and resource stocks
  • Most global markets are also concentrated but in other sectors and other stocks (5 technology stocks account for 20% of NASDAQ)
  • Markets that are concentrated are risky
  • To manage risk, Toron diversifies at the stock, sector and market levels

Consider an investor with a portfolio of 15 different oil stocks. Exposure to failure by any single company — due to bad management, poor property development, etc. — is limited. However, the entire portfolio is influenced by the price of oil. If it declines, the portfolio loses significant value.

Now, suppose that besides these holdings, 15 different financial stocks are added. The investor has limited exposure to any single entity but still faces financial industry risk.

Combine the portfolios and you get 30 different stocks. It certainly looks diversified. However, how risky is it?

It’s less risky than sector-specific portfolios but it’s overweight in oil and financials — wonderful returns if they do well, large losses if both do poorly. It’s a little too risky for most nest eggs, yet it also defines Canada’s TSX index. Fortunately, oil and financials have done well the past few years. But how long can this concentrated portfolio continue to run? Can you be sure this abnormally positive pattern of returns will continue?

The TSX was never meant to be a well-diversified portfolio. It just described the general tone of the market through aggregate stock pricing information. Yet, an investment in the TSX or with a manager that mirrors its weightings is a bet on just two sectors. If either does poorly, significant losses will ensue.

Unfortunately, all global indexes have been elevated to portfolio status. A mere 5 technology stocks account for 20% of NASDAQ!

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Why Invest Beyond Canada?

  • Canada has done very well economically
  • Canadian market lacks industry diversification
  • The economic future of any country can’t be assumed; that’s why Toron diversifies globally
  • To manage risk, Toron diversifies at the stock, sector and market levels across the globe

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The Effect of Random Events

Protection from random events comes from owning unrelated stocks in different sectors and economic regions:

  • Random events affect markets at unexpected times and in surprising ways: 9/11, SARS outbreak, hurricanes, etc.
  • Smaller events such as economic data, or changes in government or legislation have potential impacts on the market depending on the country
  • Any overly concentrated investment strategy can be vulnerable to unforeseen events: 1 random event can quickly devastate the entire portfolio
  • To manage risk, Toron selects individual stocks to avoid correlation so that random events will not affect the value of the overall portfolio

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The Big Secret to Investment Success — Managing Risk

  • Investment success over the long haul means not focusing exclusively on returns
  • Toron places great emphasis on managing risk
  • By managing risk, Toron focuses on limiting downside events so that time and compounding can help increase portfolio value

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