Three Diversification Strategies for a Perfectly Balanced Portfolio

The following is a guest post by Dan Kent, owner and writer for Stocktrades.ca. For more information about guest posting on Money Q&A, check out our guest posting guidelines.

I deal with a lot of new investors. Those who are attempting to leave their banks or fund managers and instead take control of their own finances.

As such, the question that frequents my inbox the most from those who are looking for advice is “how do I construct an investment portfolio?”

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I’ve often stated that building a portfolio is the most difficult task you can take on as a new investor. The tendency to allocate either too little or too much in a particular industry or even specific assets is a problem that leads to increased volatility for those who simply don’t want it.

I could probably write a 6000+ word piece detailing every single aspect of portfolio diversification, which would inevitably bore you to death. Instead, I’ll just talk about 3 strategies that I feel are the most important.

Hedging Your Investments

Hedging is a term a lot of readers are probably familiar with. Much like car insurance where if you were to get in an accident the insurance company (you hope) will reimburse you for your loss, hedging an investment reduces your overall risk and exposure to a negative event.

An investor can properly hedge their investments a number of ways. But three of the primary forms of hedging come from purchasing options and futures contracts, and diversification.

I’m not going to talk about options or futures hedging today, as that requires a whole other skillset in order to keep yourself out of trouble. Most investors will do just fine hedging their portfolio simply by diversifying their assets.

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Hedging Via Diversification

Going over a simple example here should at least get your mind working on the numerous ways to hedge a particular investment. Being from Alberta Canada, I’ve been exposed to the oil and gas industry almost all my life. The province has fallen on pretty tough times right now, as oil and gas companies struggle with the low price of crude oil.

If you own oil and gas stocks right now, you’re probably not fairing very well. But those who purchased refinery companies, which tend to perform excellent when the commodity is low, have probably offset some of those losses.

The lower the price of oil, the less profits realized by oil and gas companies who mine crude. However, the lower the cost of oil, the less a refinery must spend to acquire it. So, in the short term, profit margins of refineries tend to rise.

This is obviously a very small example of hedging via diversification, but it should get you thinking about other possibilities. Keep in mind, that whenever you’re hedging an investment, whether it be through derivatives like options or even through diversification, you’re reducing your overall risk. With reducing your risk, you’re inevitably reducing your overall profits as well.

It is important to find the balance between the two, as over hedging can often lead to a significant reduction in profits.

Asset Allocation

Typically, when a new investor starts to think about portfolio diversification, they simply think about the diversification of growth assets such as stocks(link to https://www.stocktrades.ca/how-to-buy-stocks-in-canada).

The way you allocate your capital in your portfolio is just as important if not more. A simple rule to follow is this:

As you get older, you need to allocate more of your capital towards lower risk investments.

The theory behind this is pretty simple. As a younger investor, you have the opportunity (not the requirement) to invest more of your capital into growth assets such as stocks because you’re nowhere near retirement. An older investor approaching retirement may want to invest their capital into more secure investments, such as bonds.

Why? Well, think of it this way. An investor in their 20’s has the ability to overcome burdening market conditions because they simply don’t need the money anytime soon. In a situation like this, this investor would be able to take advantage of higher growth opportunities and invest most of their portfolio in assets like stocks.

 If a younger investors portfolio drops by 30% in a crash, they can simply buy more shares reducing their overall cost and reap the rewards when the market returns to form.

However, an older investor who is close to retirement may have their retirement date pushed into the future if they had the same asset allocation. On a million-dollar portfolio, a 30% crash is literally years of retirement funds out the door, and the soon to be retiree simply doesn’t have 5-10 years to wait until market conditions improve, but they may be forced to.

The Rule of 100

There is a rule, one that I don’t particularly follow or endorse at all but should still give you at least a head start on some allocation strategies, and that is the rule of 100.

It is said that an investor should subtract their age from 100, and that will be the percentage of their portfolio that should be invested in growth assets. So, for example, a 30 year old should have 100-30= 70% of their portfolio in growth assets, while a 65 year old investor should have 100-65=35%.

All in all, one’s asset allocation should be directly correlated with their risk tolerance. There will be some 50-year-old investors that are more than happy to invest more of their portfolio in growth assets, because they can handle the risk. And on the flip side, there may be a younger investor who is hoping one day to pull that money out for a down payment on a house, so their risk tolerance may be much lower.

Overall Industry Diversification

This strategy is typically deployed after you’ve figured out your proper asset allocation, and it requires a fair bit of fine tuning and balancing over the course of your investment career.

A lot of people jump to the conclusion that diversification simply means owning a wide variety of stocks. I’m a fairly big contributor on some Facebook groups pertaining to investing, and there was one gentleman who was preaching diversification on a cannabis trading group.

He owned 19 different stocks. Excellent right? Well, his main problem was all 19 were from the cannabis industry.

Owning 20 stocks doesn’t mean you’re diversified. And owning 5 stocks could mean you are perfectly diversified. There is no magic number.

The important thing to know is that you cannot have too many eggs in a particular industries basket. For example, this gentleman above would probably risk losing a catastrophic amount of his money if the cannabis industry were to introduce regulations that negatively affect the sector.

A well-rounded portfolio contains a well-rounded batch of assets. This can include stocks in anything from the financial, industrial, consumer defensive or energy sectors. Many different sectors thrive when others struggle, and a well-balanced portfolio will be able to absorb the blow much better than one that is heavily focused on one area.

Industry diversification also requires consistent rebalancing in order to maintain a proper portfolio. A rise in the price of crude oil may see the energy sector of your portfolio increase, but it also causes a shift in the balance of your portfolio and should be tweaked every so often. This can be once every quarter, semi annually or even annually at tax time to allow you to harvest some losses.

A Difficult Task with a Plethora of Options

Overall, construction a portfolio isn’t an easy task. With these three concepts, you’ll at least get a head start.

It’s simply impossible to produce an article that is a one stop shop in terms of portfolio construction. There are so many elements to it that an investor really needs to sit down and organize their goals and risk tolerance prior to even starting.

I hope you liked the piece, and if you’re interested in more from me, I am the owner/writer for Stocktrades.ca, a blog designed to help investors get the most out of their investments. You can follow us on Facebook or Twitter, where we frequently post content updates.

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