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The Diversification Dilemma
Why Many Investors "Do it Right" but Get it Wrong
Diversification means far more than allocating assets among stocks, bonds and cash. It can be beneficial to diversify within each category as well.
Talk to many investors, and you'll hear a tale of woe. "I hold stocks, bonds and cash, so I'm diversified. But the markets creamed me last year. With my diversified portfolio, why didn't I do better?"
Perhaps you also "did it right" by spreading your assets over stocks, bonds and cash. But if you didn't diversify within each asset category, you're not optimally diversified.
The Perils of Overlap
Look at the equities (stock) portion of an investor's hypothetical portfolio...
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- Individual stocks — 1,000 shares in Nortel
- Mutual fund A — $10,000 in a diversified growth fund with Nortel as one of its top three holdings
- Mutual fund B — $15,000 in a growth and income fund heavily into growth stocks, including Nortel
- TSE 300 Index Fund — $20,000 spread among large-cap companies, including Nortel
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The stock allocation of this portfolio suffers from overlap — one type of stock found in all the "different" holdings. In this case, the stock portfolio is dominated by large-cap, growth stocks in a single sector — technology.
When these stocks do well, so does the investor. The problem? Markets are volatile, and stock types fall in and out of favor. The portfolio, and consequently the investor, have been too vulnerable to market swings.
Enhancing Stability Through Diversification in Depth
As Dennis Trittin, a Russell portfolio manager, contends: "Diversification is a multi-layer proposition." This example portfolio needs balancing in the small-cap and value areas. Companies with large, medium and small capitalization (total worth of their stock) often perform differently at different times. The same is true of growth and value stocks.
 A prime example? Investors who allocated all their assets into US growth-oriented technology stocks in the early- or mid-'90s did fine for quite a while. On March 10, 2000, the Nasdaq closed at its all-time high of 5048.6. But by April 4, 2001, the Nasdaq had dropped 65% to 1638.8. "If you had all your equities in US growth-oriented funds, you had your head handed to you," Trittin comments. A truly diversified portfolio would have reduced those losses.
How do you protect yourself? Consider three key diversification factors:
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- Style — combine growth and value stocks, since one style will often dominate, then give way to the other. In 1999, the Russell 300® Growth Index rose 59.36% while the Russell 300® Value Index rose only 6.38%. But in 2000 growth and value flip-flopped, when growth stocks had a negative return (-13.48%) and value stocks went up 23.95%
- Sector — spread allocations over a variety of industry types, to avoid cyclical performance and tame volatility
- Capitalization — hold stocks of large-, medium- and small-cap companies because they, too, can be driven by varying market factors creating less-than-predictable movements
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Within each category, some types of stocks will out-perform the market while others under-perform. Cycles occur within the fixed-income market, too. For example, Canadian Government T-bills may be up while mortgage-based investments are down and vice-versa. If your portfolio is truly balanced, market shifts will not affect you as greatly.
Top Performing Styles 1990-2000
Source: Russell 300&174; Growth Index, Russell 300&174; Value Index
Nesbitt Burns Small Cap, TSE 100
Russell's multi-manager approach takes diversity in depth to the next level. Russell selects multiple money management firms to direct each style and capitalization category within a single fund. With varying investment philosophies combined, a weakness in one area is further offset by strength in another.
Russell managers represent some of the best managers, too, because Russell monitors and meets with more than 1,500 money managers in 20 countries around the globe. And, Russell continually tracks its managers' performance. If a manager is drifting too far from its specified style, Russell will make a switch to assure proper asset allocation.
That diversified allocation provides the opportunity to reduce volatility and pursue goals via a steady long-term growth plan.
For more on Russell's asset allocation and multi-style processes, see the Multi Asset and Multi Style sections of the Russell Investment Approach.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Money market mutual fund securities are not covered by the Canadian Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that a money market funds will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment will be returned to you.
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