The Globe and Mail, Report on Business, Guest Column
February 16, 2006

When I talk to investors, invariably I find myself reminding them that there is no free lunch in investing. If someone is promising you higher returns, then there is a cost in the form of higher risk. Conversely, if there appears to be little or no risk, then the cost comes in the form of lower long-term returns. A good example of the latter is principal-protected notes, which are big sellers right now. For the assurance of not losing any of your invested capital, you are required to accept lower returns and pay higher fees.

It's not totally accurate to say there's no free lunch, however, because there is one. It's called diversification. If you diversify your portfolio appropriately by owning different types of securities, then you can reduce the volatility without affecting long-term returns. In other words, the portfolio will zig and zag less dramatically in the short run, but end up in the same place at the end.

There are, however, two things you need to know about diversification. First of all, it's boring. When your friend, who owns nothing but energy stocks, is bouncing off the ceiling with excitement, your portfolio will be achieving more modest gains. Gains that are almost invisible day to day or month to month. When your friend's portfolio collapses, you'll no doubt be feeling some pain, but your assets will be intact.

The other thing to remember is that if you're properly diversified, you're not going to feel good about everything you own. That's what diversification is all about. Not all parts of your portfolio will be working for you at once. If you're comfortable with everything in your portfolio, then you're not properly diversified.

This is particularly topical right now because we're at one of those times when it's easy to not be diversified. Some important market trends have been in place for a number of years, and the longer they go, the more distorted portfolios get. Simple mathematics and investor psychology lead to this situation. If a type of security outperforms the rest of the capital markets, then portfolios will become more heavily weighted in that security, unless the investor does some selling. But it's more than just math. The longer these trends persist, the more comfortable we get with them. It becomes part of our investing context, and may even take on the status of conventional wisdom. Oil prices will keep going up. The Canadian dollar is heading toward par. Canadian stocks will always beat U.S. stocks. Income trusts are better than growth stocks. This is how the world is going to work in the future. Of course, the opposite is true. The longer these trends go on, the less likely they are to persist.

With the markets we've had in recent years, Canadian investors are less diversified than they should be. They own more real estate and Canadian stocks, specifically income-oriented and natural resource stocks, than they have in quite some time. This is not unexpected because low interest rates encourage us to borrow (buy bigger homes) rather than lend (invest in bonds). And from a stock market point of view, it's not surprising we own more Canadian stocks because the S&P/TSX composite has solidly beat U.S. and international markets in each of the past four years. And bank stocks, income trusts and resource stocks have been the stars.

Where we are today feels like the flipside of a situation we had in the mid to late 1990s, when people chased growth stocks and clamoured to get their money out of Canada.

Statistics published by the Investment Funds Institute of Canada (IFIC) confirm these trends. Over the past couple of years, the flows into mutual funds have been dominated by dividend funds and monthly income funds.

Investors that have had exposure to these long-running trends should be very pleased, but shouldn't let themselves get too smug. If your net worth is dominated with holdings in the hot sectors, then you are setting yourself up for some disappointing years ahead. But it doesn't have to be that way. You can systematically rebalance your portfolio toward areas where you have little or no exposure. Large-capitalization U.S. and international stocks are attractively valued and may be candidates. Depending on your situation, it may be prudent to buy short-term notes, bonds or just pay down the mortgage.

Whatever rebalancing you do, however, be assured that it will feel lousy. You won't get any positive reinforcement for doing it. The negatives will overwhelm the positives. Who is going to tell you that investing in U.S. stocks right now is a brilliant move? Don't you know that American consumers are stretched to the limit, the country is running huge deficits and the auto sector is failing? You're crazy moving your money out of Canada.

Perhaps, but I think it's time to make sure you're properly diversified, even if it means getting a little more boring and a lot less comfortable.

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