The Importance Of Investment Diversification

WRITTEN BY Dan Kent | UPDATED ON: August 2, 2018

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**Today we have a guest post by Tom from Dividends Diversify.**

 

A little bit about Tom

Tom is a former finance and accounting professional who quit his day job and executed his financial independence plan at the age of 48. He now teaches accounting and business courses part-time at a university near his home in the upper Midwestern United States.

Tom personally manages all of his family’s investments. And, it was the passion to share his investing knowledge that led him to start Dividends Diversify in 2017.

Dividends Diversify is a personal finance blog with emphasis on investing for passive income through dividend stocks. Tom’s readers learn how to build wealth and create their own brand of financial independence.

With a name like Dividends Diversify, it seems only appropriate that Tom is going to explain his twist on an age-old investment topic. Specifically, the investing concept: diversification.

Diversification Delivers

As investors, we hear a lot about diversification. There is an old saying; no one should put “all of their eggs in one basket”. We shouldn’t just be learning how to buy stocks in Canada for example. We should be learning to expand our horizons internationally.

Diversification reduces the risk of a large loss in one holding wiping out an entire portfolio. It also serves to increase risk adjusted return on investment.

Two Primary Forms of Diversification

The two most typical forms we hear about are:

  • International diversification, and
  • Diversification among asset classifications

There is money to be made from investments all over the world, not just in your home country. International diversification capitalizes on that concept.

Diversification across asset classes plays directly to the investors risk tolerance. No tolerance for loss of your capital? You better stick to cash, short-term bonds or even Canadian bond ETFs. Do you want more potential return and are you risk tolerant? Then, put some money in small capitalization growth stocks across the globe.

A Third Form of Diversification

I personally think of diversification in a third way. That is, diversifying up and down the corporate capital structure.

I tell my business students, for every asset a company buys, they must finance it in some way. And, they finance each asset purchase within their capital structure. Corporate capital consists of liabilities and equity.

As investors, we can participate in the growth and profits of a company by investing our hard earned money not just in cash, bonds, and stocks, but all forms of corporate financing up and down the capital structure of businesses.

Here are several examples.

Short-Term Floating-Rate Demand Notes

Do you want to squeeze a little more return from your liquid cash holdings? Many companies issue these notes direct to private investors. They look and act like money market mutual funds with check writing privileges. In reality, you are investing in ultra-short term unsecured notes of the issuing company.

In exchange for taking on single company risk, you are rewarded with a higher interest rate than the typical money market or savings account offers. Some well-known companies offer these notes like Caterpillar Financial Services, Duke Energy, and Ford Motor Credit Corp just to name a few.

Bank Loans

Many companies finance their capital requirements through bank loans. These typically take the form of senior, floating rate debt.

Senior means the bank has a security interest in specific assets of the company in the event of default. Floating rate means the interest rate charged changes frequently based on the current level of interest rates.

In essence, they are like a floating rate mortgage on your home. The bank holds a security interest in the property if you default. And, they adjust your interest rate as market rates change.
As an investor, by resetting the interest rate on a periodic basis, your potential loss of principle in a rising interest rate environment is reduced. And, unlike more traditional notes and bonds, the investor’s interest payments rise along with market based rates.

The best way to access bank loans is through a fund or ETF. One of my favorite mutual funds in this area is the Fidelity Floating Rate High Income Fund (FFRHX). The expense ratio is a little higher than I would like, but I do believe active management can pay off in this area. Why? Many companies that use bank loans tend to be more leveraged and can be more risky.

Bonds

In exchange for an investor’s cash, bonds are quite simply a promise to pay that investor a series of fixed interest payments during the life of the bond. In addition, a bond includes a promise to pay back the investors principle when the bond matures.

Bonds come in various maturities ranging from a few years, to 30 years or more. In addition, they can have special features like being callable at an earlier date than maturity. Or, be convertible into the company’s stock if certain requirements are met.

Bonds carry more interest rate risk than bank loans since their interest rate is fixed. Specifically, a bond’s market value will move in an inverse relationship with market interest rates.

In contrast, bond value will move in a direct relationship with the company’s credit worthiness. In other words, a lower credit rating means a lower market price for the company’s bonds and vice versa. These risks can be reduced by buying individual bonds of credit worthy companies and holding them to maturity.

You can purchase individual bonds through your brokerage account, or by purchasing a mutual fund, or an ETF. I prefer the ETF route. You can’t go wrong with an ETF from Vanguard for its low cost and instant diversification like the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).

Preferred Stock

Preferred stock is essentially a hybrid security that has a mix of bond and common stock characteristics. The investor doesn’t have the upside potential like common stock. In exchange, the investor normally receives a hefty dividend yield. In addition, the holder receives preferential treatment above common stock holders on the receipt of those dividends.

Banks, insurance companies and utilities are big issuers of preferred stock financing. Like bonds, you can buy individual company issues through your broker or invest through mutual funds and ETFs. I do both. The I Shares US Preferred Stock ETF (PFF) is one example of a low cost fund with many preferred stock holdings.

Common Stock

If you are a loyal reader of Stocktrades.ca, there is not much I can tell you about investing in common stocks that you do not already know. By owning the common stock of a company, you are part owner in that business. And, participate in all the potential rewards and risks that go with ownership.

I favor dividend paying common stocks, particularly ones with low payout ratios. I like my claim on the company’s earnings per common share to be partly paid out to me in dividends. Maybe you knew that since I write for Dividends Diversify. There are many great dividend paying companies located across the world, but especially in Canada. One of my favorites is Enbridge (ENB) headquartered in Calgary.

Wrapping It Up

As you look at your investment holdings, don’t forget about good diversification practices. Take a look at all the ways businesses finance their cash needs through their capital structure. See if any of these financial instruments should have a more prominent place in your portfolio:

  • Short-Term Floating-Rate Demand Notes
  • Bank Loans
  • Bonds
  • Preferred Stock
  • Common Stock

Do you diversify across the entire corporate capital structure? Are there other forms of corporate financing you invest in but are not discussed here?

Disclosure

Long: FFRHX, VCIT, PFF and ENB.