Diversification is protection against potential losses, especially if you are investing in growth stocks. A general idea about diversification is that you lose growth potential and gain relative safety of your capital, which is what everyone wants. Exactly how much growth potential you lose and the probability that you won’t suffer a loss is hard to calculate.
I will be using the compound annual growth rate (CAGR) for the evaluation of the growth potential of the stocks. Let’s say you have two stocks with similar CAGRs when calculated for the past five years. And you have $40,000 to invest. What would be your best option: to invest $20,000 in two of them, or invest all the capital in one? From a diversification perspective, the first option is better.
And it doesn’t impact your returns much. The returns from your capital in two similarly performing stocks will add up to nearly the same number as all your capital in one stock would. But what if you had three stocks, among which the fastest-growing and the least-growing stock average out to the growth of the medium-growing stock? How would your numbers pan out then?
One of the Big Five
Toronto-Dominion (TSX:TD)(NYSE:TD) has always enjoyed a dominating position among the Big Five when it comes to growth. It enjoys the same stability that the country’s banking sector does and, as an aristocrat, offers a decent enough yield of 3.94%. The bank has a CAGR of 6.4% when calculated for the past five years.
If we put $20,000 out of your TFSA into TD, and the bank follows the same growth rate in the future, you may be sitting on over $27,000 in five years.
As the second-largest bank in the country, a Dividend Aristocrat with a sizeable presence in the U.S., and growth-oriented strategies, TD seems like a relatively safe bet as a growth stock.
An aerospace company
Heroux-Devtek (TSX:HRX) is an aerospace company that specializes in landing gears. It designs, develops, repairs, and overhauls actuation systems. The company primarily operates in North America and Europe through a total of 18 sites. It also has the distinction of being the third-largest gear company in the world.
This $773 million market cap company has seen decent growth in the past five years. The market value increased by over 111% in that period, resulting in a CAGR of 16.12%. So, $20,000 in Heroux-Devtek might be worth over $42,000 in the next five years.
An Insurance company
Intact Financial (TSX:IFC) is the largest property and casualty insurance provider in the country. The company operates under six different banners in the country and other North American countries. On average, IFC gives out $10 billion in premiums every year, and an estimated 20% of Canadians rely on it for insurance.
IFC is also a long-standing dividend with 14 years of growing payouts. It saw a pretty steady run from 2015 to 2019, but the company took off in the past year. IFC’s five-year growth in market value is about 69%, and the CAGR is 11%. If it continues, $40,000 in IFC might boost your capital to $67,000 in five years.
The combined growth of TD and Heroux-Devtek is just $2,000 more than the total capital’s growth in IFC. But this gap is expected to widen in the future. If the growth rates of all three companies persist, in 20 years, $40,000 in two companies will be worth over $140,000 more than all of it in IFC. And that’s primarily due to the higher growth of Heroux-Devtek stock.
This isn’t an argument for or against diversification. The numbers don’t pan out the same way. They rarely grow how investors expect them to. But as an investor, you should understand the numerical consequences of your investments. It may help you make better decisions with your hard-earned money.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Adam Othman has no position in any of the stocks mentioned. The Motley Fool recommends INTACT FINANCIAL CORPORATION.