SENSIBLE DOLLARS

Are your investments more concentrated than you think?

By Allan Kunigis

Allan Kunigis is a Canadian-born freelance financial writer based in Shelburne, Vermont. He has written about personal finance for more than two decades. He is the author of A Kid’s Activity Book on Money and Finance: Teach Children About Saving, Borrowing, and Planning for the Future, published in September 2020.

A basic tenet of investing is that too many eggs in one basket could be too risky. For example, if all your money is invested in a single stock or industry and it crashes, your financial well-being will fall, too. But you might not be aware of how many of your eggs are actually in the same or a similar basket, especially when it comes to Canadian stocks.

There are many aspects to diversification. By far the most important consideration is broad asset-class allocation -- a fancy way of saying your mix of stocks, bonds, and cash. Let’s say you opt for a mix of 60% stocks, 30% bonds, and 10% cash, a fairly common allocation. Drill a bit further. Your stock investments should be spread across many companies, industries and economic sectors, like technology, health care, financial stocks, and energy stocks. That’s because there are times when one sector might do poorly but another performs well, balancing one another.

One quick and easy way to diversify into many stocks is through mutual funds or exchange-traded

funds (ETFs). Rather than buying shares of stocks in dozens of companies, you simply purchase shares in a mutual fund whose professional managers invest in many different stocks in a variety of industries and sectors.

A popular and cost-effective way to “buy the market” is through a broad stock index fund. Instead of trying to “beat the market” or outperform it by picking stocks, as an actively managed mutual fund would, an index fund simply seeks to match the performance of an index by buying a basket of all its stocks and holding on to them. That does away with costly research, trades, and taxes incurred in those transactions.

That’s great in principle. But now let’s see what it really looks like and how much diversification it achieves.

TSX OR NOT TSX?

The big stock index considered as representative of the Canadian stock market is the S&P/TSX Composite Index. It tracks the stocks of roughly 250 of Canada’s largest companies. Consider it Canada’s equivalent of the S&P 500 Index in the United States.

The S&P/TSX isn’t a bad way to quickly capture the Canadian stock market. But the problem is that the TSX and the Canadian stock market are not that diversified. To begin with, the TSX is made up only of the largest Canadian companies. Second, almost one-third of it consists of the financial services industry, which is dominated by five giant banks. The fortunes of those five banks will heavily influence your financial fortune. If they do well, you will. If they don’t do as well, you won’t, either.

I don’t really call that diversification.

BANKS HAVE DONE WELL

In fairness, I need to admit that over the past few decades, these Canadian financial giants have performed incredibly well. For example, an investment in Royal Bank (RBC) in May 1996 would be worth 30 times as much today. So, $10,000 invested in 1996 would be worth roughly $300,000 now -- a true success story.

But consider a tale of failure: Nortel. At one point, during the dot-com boom, it dominated the entire Canadian stock market, accounting for more than one-third of the valuation of all companies listed on the Toronto Stock Exchange. A decade later, it filed for bankruptcy and its stock price tumbled 79%. Another eight years later, it had settled all its bankruptcy proceedings, leaving a lot of former employees, pensioners, and shareholders with enormous, painful losses.

Neither story -- the glowing success nor the painful failure -- could truly have been predicted decades earlier. That’s why we diversify.

THINK SMALL

One way to wean yourself from too much reliance on Canada’s big banks is to put some of your investment dollars into a fund that captures the performance of the TSX SmallCap Index, which tracks Canada’s smaller company stocks. Not only are its constituents much smaller, they’re also in a greater variety of sectors: They include materials (24.8% of the index), energy (13.9%), industrials (12.9%), and real estate (10.4%). So, it’s more diversified.

To complement your exposure to Canada’s big banks plus the stock of railway and transportation giants CN and CP and e-commerce giant Shopify -- all of which dominate the S&P/TSX index -- with the TSX SmallCap Index, you’d own shares of a bunch of companies you’ve probably never heard of, including:

• North West Co., a multinational grocery and retailer, which returned 56% from April 20, 2020, to April 19, 2021.

• Intertape Polymer Group, which makes various tapes used for sealing boxes and repairing plumbing. Its stock price returned 184% over the past year.

• Enerplus Corp., a Canadian independent oil and gas producer. Its stock gained 187% over the past 12 months.

• Russel Metals, a large metal distribution firm.

It gained “only” 117% since May 2020.

The S&P/TSX isn’t a bad way to quickly capture the Canadian stock market. But the problem is that the TSX and the Canadian stock market are not that diversified.

I swear I didn’t cherry pick these. I selected them as examples because they were in the top 10 holdings of the S&P/TSX SmallCap Index and I had never heard of them.

Granted, the period from April 2020 to April 2021 was an incredible one for stocks, as they recovered from a brief crash in March 2020 and were propelled by favourable financial conditions, thanks to central banks doing everything they could to save the financial system from the impact of Covid lockdowns.

In fairness, these are the comparable returns for the same one-year period for the four largest stocks in the S&P/TSX Composite Index:

• Royal Bank: + 53%

• Shopify: +82%

• TD Bank: +63%

• CN: +51%

CHOOSE BOTH

The point isn’t the performance of large stocks vs. small stocks in any one year. It’s simply: Variety. Diversity. Less concentrated risk. In terms of performance, in any given year, largecompany stocks might outperform smaller company stocks, or vice-versa.

The idea isn’t to choose one or the other. Instead, invest in large-company and small-company stock for more diversity and less overall risk.

TRAVEL BEYOND THE BORDER (REMEMBER THAT?)

In addition, as mentioned at the top, having a good mix of bonds/bond funds as well as stocks/ stock funds will add essential diversifi cation. Also, understand that Canadian stocks make up only a tiny fraction of all stocks in the world. For that reason, Canadian investors should seriously consider a lot of exposure to U.S. stocks, which make up roughly half of all stock market capitalization (total value) globally. Even if there are still restrictions on your international travel, don’t quarantine your money!

And go beyond North America: Invest in funds that include European and Asian stocks, and both largecompany and small-company stocks. Invest in stocks in developed markets (Germany, United Kingdom, Japan, etc.) and emerging markets (China, Brazil, India, Russia, South Africa, etc.).

Remember those eggs in that basket? You want them in many baskets that will perform differently in various economic and political situations. That could lower your risks and help you achieve better riskadjusted returns, which means earning more for any given level of risk exposure.

Okay, class dismissed! I hope you didn’t lose your concentration but I hope your investments do!