How Deep Does Your Diversification Go?

One of the goals of a well-constructed portfolio is to reduce the overall risk without sacrificing return. This is partly achieved through diversification, a concept many people understand as ‘not putting all your eggs into one basket’.

The simplicity of this statement makes two important assumptions. Firstly, that the benefit of spreading your eggs over multiple baskets also assumes you don’t make the mistake of storing all the baskets on the same table, in the same room of one house. This can be compared to buying the iShares S&P TSX 60 because you want the diversification benefit of owning the 60 largest Canadian companies instead of buying only Royal Bank stock. It’s true that you have achieved some diversification by dividing your eggs among a few baskets, but the problem is these baskets are still concentrated in a few sector ‘tables’, in the equity ‘room’ of the Canada ‘house’.

The second important factor in diversification is how the baskets, tables, rooms and houses are affected in relation to one another when subjected to a risk factor. As a simple example, the eggs separated into a closed, refrigerated room are not likely to be affected by leaving the thermostat temperature too high in another room.

We can conclude that the relationship between the thermostat temperature and the shelf life of the eggs in the refrigerated room are uncorrelated or at least minimally correlated. However, if the electricity were to fail, then the eggs in the refrigerated room and room with the thermostat would both be affected. In this way, the shelf life of both sets of eggs are positively correlated to the availability of electricity. Correlation and the risk behavior between individual investments and their asset classes, such as equities and fixed income is equally important.

For example, if you have a Canadian balanced fund with 60% equity & 40% fixed-income, the benefits of diversification are based on the historical relationship of fixed-income values going up or remaining level when equities are declining (negative to no correlation).

But what happens when the value of the two asset classes start moving together (positive correlation) – as we saw going into and coming out of 2008? This has the potential to create large and unwanted swings in the value of a portfolio. It may make sense to consider adding additional ‘alternative’ investments which are minimally or uncorrelated to the other traditional asset classes in a portfolio.

This can include things like alternative strategies (long/short hedge funds, options) or assets (commodities, currency, infrastructure, REITs). For many investors, access to these types of investments were limited and often more restrictive until recent changes to retail investment regulations.

With the introduction of ‘liquid alternatives’, more Canadians will have access to these investment choices going forward. Check with your advisor if adding ‘alternative’ investments to your portfolio is appropriate for you.