Investing for Financial Success: Understanding Diversification - Concept 1

One day when I was young, I saw my parents doing paperwork one afternoon. I was curious about the columns and lines of numbers they were writing down in pencil. My dad explained to me that they had lent some nice people money to buy a home. It was the early ’80s and well before computers were used, so they were manually recording the money they lent, the interest paid, and the money still owed.

When I asked why they would do that, my father gave me my first, and perhaps most memorable, financial lesson. He explained that while it’s good to work hard for your money, it’s even better to have your money work hard for you. This conversation and their willingness to teach me what they knew of investing — long before mutual funds, ETFs, etc. were readily accessible — is one of the biggest reasons why I manage people’s investments today.

Unfortunately, we no longer live in a world where interest rates pay the 10-12 per cent my parents were making back then. Today, investing properly is not only much more complicated, but it can also be considerably riskier.

At the end of the day, what’s most important to me is to help my clients achieve the financial goals that are most important to them and those they care about. This usually requires advanced financial and tax planning, but it also involves ensuring the returns on their investments are such that they can support them throughout their lives.

With that in mind, this and subsequent posts in this series will focus on the investment side of things. My five concepts will provide some solid investment advice that can help increase your net worth in a strong and prudent manner.

Concept 1: Diversify yourself!

Diversification is a term frequently used in the investment world, but seldom practiced. Even those who think they have their investment eggs in different baskets, may be vulnerable to potential pitfalls.

Trap One: Diversification is just about the number of investments you own

Just because you’re invested in a number of companies doesn’t mean you’re diversified. Let’s take the Canadian banking industry, for example. You’re not getting the diversification you think you are by owning all five major Canadian banks in your portfolio. The entire industry is influenced by similar factors like interest rates, money supply, the strength of the economy, etc.

This is not to say each bank is 100 per cent alike, but they’re similar enough that when the markets crashed in 2008/2009, they were all down by about 50 per cent at their lowest point. Not the diversification most people were counting on.

Various industries have various degrees of similarity between their different companies, so it’s a good idea to ensure you are adequately diversified between industries and asset classes — and geographically too, for that matter.

Trap Two: “My company is safe”

Employees got a rude awakening during the dot.com crash of 2000. Many had a large percentage of their net worth in the company they worked for. As a result they saw their net worth obliterated. Unfortunately being too close to a particular company gave them a false sense of comfort and knowledge.

This is a common mistake considering the generous incentives employees are given to buy shares in the companies they work for. That being said, employees should take advantage of situations where they can acquire investments at a discount or have a percentage of what they contribute matched. However, it’s a good idea to reduce their risk by liquidating some of those shares after the vesting period has passed to diversify properly.

In my next post, I’ll discuss Concept Two — the importance of asset allocation when investing.