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Weekly Insight

Playing safe

TORONTO (GlobeinvestorGOLD) — The fall of 2005 saw corrections in each of the two most popular retail investments: income trusts and oil & gas. The markets seem to have healed the gash but it does remind investors that too much of anything can be bad for your financial health.

And that’s why investment advisors say it until they’re blue in the face: “diversify”. It’s the most commonly dispensed financial advice but perhaps the least understood. As the year comes to a close, it’s a good time to review the basics of diversification.

A wise investor does not diversify to increase returns. A wise investor diversifies to lower risk – and as a result increases returns. Diversification spreads risk throughout sectors, asset classes and investment products.

As an example a high risk, small cap technology stock could double in value overnight. It could also lose half its value overnight. A low risk, high quality bond is almost guaranteed to bring in a relatively small return in one year. By combining the two in a portfolio you retain the potential for strong returns while minimizing the potential for big losses.

There are two basic components to a diversified portfolio – growth and income. A typical small cap technology stock has the potential to generate growth but does not provide income. Returns are derived from its increase in value resulting from high demand from other investors. A profit is not realized until it is sold at a price higher than the original purchase.

In contrast, income is provided to investors while they still hold the security. The most obvious example is a bond which generates yields throughout its term or upon maturity. Income trusts and dividend stocks are popular because they have the potential to provide both. In addition to providing investors with income, they trade on the open market and create capital gains or losses, which are not realized until the product is sold.

For retail portfolios the split between income and growth should be between sixty per cent and forty per cent. Investors with a higher tolerance for risk should have the bulk of their assets in growth investments and those with a low tolerance for risk should have most of their assets in income investments. Retail investors should increase their weighting in income investments as they get older because there is a shorter period of time between the present and retirement.

More elaborate portfolios can also be diversified through currencies, gold and derivatives. There comes a point where diversification becomes hedging – and the number of hedging strategies is infinite.

For retail investors, diversifying properly means creating the right mix of assets that will result in what is called “synergy” and not just a mish mash of holdings. A good way to do that is to watch the pros. The best examples of portfolio diversification at work are balanced funds.

The pros with the best balanced fund so far this year are Middlefield Group. The Middlefield Canadian Balanced Class fund has returned 24.5 per cent since January first and has managed to average nearly 15 per cent annually over the past three years. It’s a tiny fund of about four million dollars but it packs a punch. Roughly 75 per cent of its assets are in stocks and 25 per cent are in bonds or cash – implying a higher risk factor. Obviously the risk paid off.

At the other end of the risk spectrum National Bank Mutual Funds chose to play it safe with its Conservative Diversification fund. The management team from Natcan Investment Management put only nine per cent of the fund’s $43-million into stocks, and 80 per cent in fixed income. Safety has a price – that fund has only returned four per cent so far this year. The fund has also produced a steady return of 5.5 per cent annually for the past three years.

The two funds highlight a basic truth of investing: it’s very difficult to get big returns with a low degree of risk – but if you can get a bit of each, you’ve got it made.

This article first appeared on GlobeinvestorGOLD.com. If you'd like to profit from the insight of more than 30 financial experts and columnists, including Dale Jackson — sign up for a free trial to GlobeinvestorGOLD.com.

© 2007 The Globe and Mail. All rights reserved.

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