Having established an asset mix, you can then look for securities using a process that brings additional layers of diversification to the portfolio including diversification by geographic region, fund objectives, and management style.

These additional layers of diversification add two major benefits to your portfolio: 1) they help reduce the risk within the portfolio; and 2) they help make the portfolio more efficient. The litmus test for the process is really quite simple: Does the end portfolio produce better than average returns with lower than average risk?

The Investing World Is Changing

What we are talking about is a major change in mindset from thirty years ago. It was not that long ago, when the purchase of a mutual fund was itself, enough to provide diversification. Mutual funds finally allowed individual investors the opportunity to reduce the company specific risk associated with individual stocks.

We recall the 1970s when portfolio theory meant trying to find ways to reduce or ideally, eliminate company specific risks. You could offset say the risk of an airline company which is negatively affected by changes in the cost of jet fuel, with an oil company, that benefited from higher fuel prices.

In this example we have the same fundamental issue, but with a much different impact on in very different industries. Theoretically, if you had shares of an oil company and an airline company, you would eliminate much of the risk associated with changes in the price of oil. Taking that to the next level, a portfolio of 15 to 20n well-thought-out stocks in a cross section of industries should reduce 95% of company-specific risks. 

But who can afford to buy 15 to 20 Canadian stocks? The cost for such a portfolio could be as high as $100,000. And that’s where mutual funds excel. A good-quality Canadian equity fund easily replaces a portfolio of 15or 20 well-thought-out Canadian stocks. And, for added comfort, you get a professional portfolio manager to guide you along the path at the right time in the business cycle.

Mutual funds provide instant diversification within an asset class. A Canadian equity fund provides instant diversification within the Canadian stock market. A Canadian bond fund provides instant diversification within the Canadian fixed-income market. Balanced funds go even one step further, providing diversification in both the equity and fixed-income markets.

But mutual funds do not eliminate market risk. But in the 1970s and for most of the 1980s that did not matter. Market risk was not so important, and anyway, there was no effective way to eliminate it. So the thinking was quite straightforward: Buy a good-quality, well diversified mutual fund and relax.

October 1987 changed all that. Before the stock market crash, few investors believed that market risk would ever have much of an impact on their pocketbooks. But when the Canadian stock market fell more than 20% in one day, so did most Canadian equity mutual funds. That one event redefined the role of diversification.

Asset allocation became a buzzword after the 1987 stock market crash. And why not, because it was the only strategy that actually defended investors during the crash. That lead to the idea of building portfolios of mutual funds. Books were written on the subject (Between us, we wrote five such books).

The concept was straightforward. A mutual fund eliminated company-specific risk; a portfolio of funds representing different asset classes reduced market risk (It still couldn’t eliminate risk itself, mind you. But a portfolio of funds representing different asset classes and geographic boundaries does reduce some of the volatility attached to market risk).

A portfolio of 6 to 10 mutual funds lets you sleep at night. The problem, of course, is making sure that each fund you choose is actually bringing some added value to the portfolio. It doesn’t help much to have three funds doing exactly the same thing.

It also doesn’t help if you hold a portfolio of funds, without really knowing what each fund has to offer. The funds may be the right choices, but without a frame of reference, you don’t know.

The Better Way

There is a better way to build portfolios: Buy the best funds in each category, without regard to specific fund families. Rather than getting into the debate around index funds versus actively managed funds, pay attention to a rigorous portfolio building process that brings together the best funds within a well-diversified format.

Will your portfolio be immune to the ebbs and flows of the business cycle? Not by a long shot. However, it will be as insulated as possible from the economic shocks. You can rest assured that you did all you could do to smooth out the fluctuations. But most importantly, you will have a framework for examining your choices or your advisor’s recommendations.

So what’s new? It’s the realization that selecting the right portfolio involves a bit of science and a lot of art. The science lays the foundation for making decisions; the art is mixing and matching within a portfolio to provide above-average risk-adjusted performance.

We’ll be back to reviewing your portfolios over the next few weeks. You can e-mail us at rcroft@croftgroup.com. Send us your profile, your goals, your risk tolerances (that get-to-know-yourself questionnaire we talked about) and your current holdings. If we choose the portfolio, we will review it in the column. Names always being withheld to protect the innocent.