Don't Chase Performance: Stay Diversified* to Reduce Risk

Kate Warne, Ph.D., CFA
Canadian Market Strategist

Much of the rise in the S&P/TSX** Composite (TSX**) this year is due to gains in commodity stocks in the materials (mining and metals) and energy industries. Since these two industries now represent more than half of the value of the TSX**, your portfolio’s performance has probably lagged. While no one likes to own equities that underperform, we think you should be reassured, not distressed, when you learn why. And it’s important to consider taking steps so that your portfolio doesn’t become too sensitive to commodities risks.

Gainers and Losers in the TSX**
At the end of June, the TSX** was up about 4.6%. Looking more closely, two strong sectors — energy and materials — represent 53% of the TSX** and together gained about 24% in the first half of the year. Excluding these two, the rest of the TSX** was down 14%. Obviously that includes individual stocks that are both up and down, but a 14% decline may be a better picture of the performance of portfolios with little in energy and materials.

We recommend investors own better-diversified portfolios than the TSX**. If your portfolio is better-diversified*, it has probably lagged the TSX**, and you may be disappointed. We believe you should keep your portfolio well-diversified* and resist the temptation to chase performance. If you are like most investors, you don’t want the volatility that would result from having so much of your portfolio tied to commodity prices. They’ve historically dropped as quickly as they’ve risen recently. While we don’t know when or whether that will happen, we think having a large percent of your portfolio in energy and commodities adds a lot more risk than most investors want to take.

Why Are Energy and Materials Up?
While world economic growth slowed in 2008, the demand for many commodities remains strong. Usually commodity price cycles are relatively short, but this episode of rising prices has lasted longer. The main reasons are:

The history of low investment due to low returns
A reluctance by producers to expand production rapidly
Specific industry issues that have disrupted supplies or restrained supply growth

Although it may take longer for the responses to higher prices and greater supplies to trigger lower prices, we believe eventually we’ll see down price cycles for most if not all commodities. When prices fall, in some cases they could remain higher than past lows. But expectations of continuing high commodity prices are increasingly widespread, making us cautious about the potential for good investment returns. A few exceptions are stocks such as integrated energy companies that still appear to reflect lower oil prices.

Is This Like the Tech Bubble?
We don’t know yet. The continuing rise in energy and commodity prices is attracting some investors who usually would not want to own such volatile stocks. Chasing performance may work short term but is rarely, if ever, successful over time, just as we learned in the tech bubble.

Unfortunately, it’s difficult to judge a bubble when it is still growing, but we think there are a few warning signs. Nortel’s weight in the TSX** grew rapidly at the end of the 1990s, and when it peaked in 2000, Nortel alone represented more than one-third of the value of the TSX**. Today Nortel is 0.3% of the TSX**.

What Should Investors Do?
Whenever a sector or a specific stock becomes a large percent of the TSX**, we suggest being cautious and owning a much smaller percent in your portfolio. Instead of investing more than half in energy and materials, we think those sectors should be less than 15% of your equity portfolio.

Contact your Edward Jones advisor for a portfolio review to determine if you need to rebalance to align the industry weights in your equity portfolio with our recommendations. We recommend:

Investing 11% of your equity portfolio in energy
Upgrading the quality of your energy holdings if needed
Keeping no more than 5% in materials and other commodity-related stocks, if any, or considering a diversified* mutual fund that owns them so that you have the fund manager watching your investment for you

Contact your Edward Jones advisor today for an appointment.

*Diversification does not guarantee a profit or protect against loss.
**The TSX Composite is an unmanaged index and cannot be invested into directly.

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Quotes & Watch List Current Rates Market Updates Market Commentaries & Perspectives Daily Commentary Edward Jones Perspectives	Don't Chase Performance: Stay Diversified* to Reduce Risk Kate Warne, Ph.D., CFA Canadian Market Strategist Much of the rise in the S&P/TSX Composite (TSX) this year is due to gains in commodity stocks in the materials (mining and metals) and energy industries. Since these two industries now represent more than half of the value of the TSX, your portfolio’s performance has probably lagged. While no one likes to own equities that underperform, we think you should be reassured, not distressed, when you learn why. And it’s important to consider taking steps so that your portfolio doesn’t become too sensitive to commodities risks. Gainers and Losers in the TSX At the end of June, the TSX was up about 4.6%. Looking more closely, two strong sectors — energy and materials — represent 53% of the TSX and together gained about 24% in the first half of the year. Excluding these two, the rest of the TSX was down 14%. Obviously that includes individual stocks that are both up and down, but a 14% decline may be a better picture of the performance of portfolios with little in energy and materials. We recommend investors own better-diversified portfolios than the TSX. If your portfolio is better-diversified, it has probably lagged the TSX, and you may be disappointed. We believe you should keep your portfolio well-diversified and resist the temptation to chase performance. If you are like most investors, you don’t want the volatility that would result from having so much of your portfolio tied to commodity prices. They’ve historically dropped as quickly as they’ve risen recently. While we don’t know when or whether that will happen, we think having a large percent of your portfolio in energy and commodities adds a lot more risk than most investors want to take. Why Are Energy and Materials Up? While world economic growth slowed in 2008, the demand for many commodities remains strong. Usually commodity price cycles are relatively short, but this episode of rising prices has lasted longer. The main reasons are: The history of low investment due to low returns A reluctance by producers to expand production rapidly Specific industry issues that have disrupted supplies or restrained supply growth Although it may take longer for the responses to higher prices and greater supplies to trigger lower prices, we believe eventually we’ll see down price cycles for most if not all commodities. When prices fall, in some cases they could remain higher than past lows. But expectations of continuing high commodity prices are increasingly widespread, making us cautious about the potential for good investment returns. A few exceptions are stocks such as integrated energy companies that still appear to reflect lower oil prices. Is This Like the Tech Bubble? We don’t know yet. The continuing rise in energy and commodity prices is attracting some investors who usually would not want to own such volatile stocks. Chasing performance may work short term but is rarely, if ever, successful over time, just as we learned in the tech bubble. Unfortunately, it’s difficult to judge a bubble when it is still growing, but we think there are a few warning signs. Nortel’s weight in the TSX grew rapidly at the end of the 1990s, and when it peaked in 2000, Nortel alone represented more than one-third of the value of the TSX. Today Nortel is 0.3% of the TSX. What Should Investors Do? Whenever a sector or a specific stock becomes a large percent of the TSX, we suggest being cautious and owning a much smaller percent in your portfolio. Instead of investing more than half in energy and materials, we think those sectors should be less than 15% of your equity portfolio. Contact your Edward Jones advisor for a portfolio review to determine if you need to rebalance to align the industry weights in your equity portfolio with our recommendations. We recommend: Investing 11% of your equity portfolio in energy Upgrading the quality of your energy holdings if needed Keeping no more than 5% in materials and other commodity-related stocks, if any, or considering a diversified* mutual fund that owns them so that you have the fund manager watching your investment for you Contact your Edward Jones advisor today for an appointment. Diversification does not guarantee a profit or protect against loss. *The TSX Composite is an unmanaged index and cannot be invested into directly.	Find an Edward Jones financial advisor*. Find now »