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Beginners: Canadian Do-it-Yourself Index Investors May Not Be Properly Diversified

When it comes to portfolio diversification, most investors immediately think of diversifying across various sectors to reduce systematic risk. Sector diversification is arguably the most important form of diversification, but it’s not the only form.

Most investors would stop at sector diversification, completely neglecting geographic diversification and diversification across market caps in the process. Sure, it’s true that diversification loses its effectiveness after a certain point, and odds are, you’d be fine as long as you’re diversified across various sectors with at least 10 stocks in your portfolio. But as a Canadian investor, you’re doing yourself a great disservice by investing 100% of your capital into TSX or TSXV-traded securities, especially if you’re a passive investor who’s heavily invested in the S&P/TSX Composite Index (TSX:^GSPTSE). By being heavily invested in this index, not only would you not be geographically diversified, but you wouldn’t even be properly diversified across sectors.

There are perks to remaining invested domestically, including the Canadian dividend tax credit and potentially lower MERs, on average, but I’m sure you’d find that your returns over the last decade would have been abysmal versus what you’d get if you investing in emerging markets or even U.S. indices due to improper diversification.

I still believe Canadian investors should be invested in their own country, but preferably not through the Canadian index fund. The index includes a nice sample of many Canadian businesses across all sectors, including the few tech stocks that exist on the TSX; however, unlike many other indices, the TSX is not a suitable one-stop-shop investment index.

The TSX is heavily weighted towards the energy and financial sectors, leaving your portfolio lacking in “essential nutrients” (other sectors), including tech, healthcare, and consumer staples, all of which are scarce on the TSX. Tech stocks, such as BlackBerry Ltd. (TSX:BB)(NYSE:BB), are great names to own in your portfolio, but in a cap-weighted index, the exposure you’d get would be a mere drop in a bucket that’s essentially filled with oil.

If you’re still keen on staying primarily invested in Canada, but you want to be properly diversified across sectors and other geographies, you may find it worthwhile to roll up your sleeves to become an investor in individual stocks. That way, you can create your own diversified portfolio of TSX-traded stocks, ensuring that you’re properly diversified across all sectors, properly nourishing your portfolio with all the “essential nutrients” it needs to thrive over the long term!

Also, it’s also possible to obtain “indirect” exposure to foreign markets like Europe and the U.S. with various TSX-traded stocks, such as Alimentation Couche-Tard Inc. (TSX:ATD.B), which has essentially grown to become global name, despite having strong roots in Canada.

Bottom line

Being a do-it-yourself investor and constructing your portfolio with low-cost domestic index funds can save you a tonne of fees over the long haul, but if you don’t properly educate yourself, you could end up being undiversified without realizing it.

If you’re one of the investors who’s overexposed to the TSX index, you can either supplement your portfolio with foreign indices (hedged if you’re worried about currency risk), such as the S&P 500, construct your own portfolio of individual Canadian stocks, or do a combination of both.

Stay hungry. Stay Foolish.

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Fool contributor Joey Frenette owns shares of ALIMENTATION COUCHE-TARD INC. The Motley Fool owns shares of BlackBerry. Alimentation Couche-Tard and BlackBerry are recommendations of Stock Advisor Canada.

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