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BookingAlpha Option Trading Advisory

Tuesday, September 13, 2016

The Lie

For investors, there is no doubt that putting money in several business, as opposed to just one, reduces risk. It "diversifies" you. And, while we're at it....let's just buy an index, guaranteeing total diversification and risk reduction instantly, as suggested by our friends Jack Bogle and Warren Buffet. 

There are unquestionable benefits to investing in indexes: simplicity, low expenses, and for many, the inescapable reality that they wouldn't out perform anyways by being active traders. However, "risk reduction" is not really one of those advantages always mentioned when discussing indexes.

Take the Canadian markets for example, personalized by the S&P/TSX COMPOSITE index, or as many people call it, just "the TSX". This is a good example because it is also representative of what happens with many indexes on the planet.

You would think you have really reduced risk by investing in the TSX. However, a closer look at its components reveals a different picture:

Two sectors alone make up most of the index (almost 60%). Three if you want to be more inclusive and democratic.

Financials: (banks and insurance companies) make up more than a third of the index
Energy-related companies tied to oil and natural gas prices account for one fifth.
Materials companies, which are largely exposed to gold and base metal prices (copper, zinc, nickel, etc.), total another good chunk.

As a result, these three sectors make up almost 70% of the index, and due to their nature, make the index highly susceptible to the prices of commodities such as Gold and Oil. Therefore, nobody can look you in the eye and tell you that you have reduced your risk by following the TSX index.

No wonder the Canadian markets suffered a 26% draw-down last year (Apr 2015 - Jan 2016) during the commodities crap-storm.

Most economies aren't nearly as powerful and diversified as the American economy. Therefore, most country specific indexes suffer this flaw to one degree or another.

By investing in indexes, our pals Bogle and Buffet probably mean something like VTI (Vanguard's Total Stock Market Index), or perhaps the S&P500 Index:

The top three sectors account for only about 50% of the index and they are not nearly, if at all, related to the volatile world of commodities. Looking at the rest of the sectors, you quickly notice that it is a much better balanced index, when even the sixth sector (Industrials) still represents almost 10% of the index.

But, back to the Canadian market...
If you invest in it, you may reduce your risk by creating a portfolio of mature companies where you take control over those insane sector allocations. You are not suddenly taking too much more risk by investing in companies instead of the index. If there is one thing the Canadian market has, is a bunch old wolves operating, let's face it, in Oligopoly mode, in heavily protected, regulated and hard to penetrate markets. With almost non-existent foreign competition. So, the risk of investing in a couple of large banks such as RBC and TD; a couple of energy companies such as Enbridge and TransCanada; a couple of Telcos (Rogers, Telus); spice it up with something like Canadian National Railway and then Emera and Fortis (electricity), is not really a greater risk than investing in the TSX index. And controlling those absurd sector allocations yourself, then yes, you have less risk. As controversial as it may sound.

Not by investing in an index, are investors suddenly reducing risk. In some of them, yes, but it's definitely not always the case.


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Cons of Index Funds: the case against Passive Index Investing 
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Invest and Retire before you die 
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