This article was first published in the National Post on February 4, 2023. It is being republished with permission.
by Tom Bradley
“Any word that’s really important is also confusing.”
This according to marketing guru Seth Godin. He explains, “Words like trust, love, friend, fair, honest, lead, connect, authentic, justice, dignity — they have dozens of different meanings. Perhaps that’s because they’re important.”
His post got me thinking about the words we use to communicate with clients. Is what we’re saying being received as we’d hoped? According to Godin, almost assuredly not.
Below is my attempt to clarify the meaning of three frequently used investment terms.
Diversification is the practice of owning an assortment of investments in different asset classes, industries, geographic regions and currencies that each contribute to returns in different ways at different times. It’s often referred to as “the only free lunch” in investing, because by not putting all your eggs in one basket (or sector, country or strategy), you’re likely to have a smoother ride without sacrificing return in the long term.
The confusion around the term comes from its lack of precision. How well it works varies from cycle to cycle. In most cases, diversification makes market dips less painful. For example, if Canadian stocks are suffering from a commodity collapse, foreign stocks in other sectors are providing positive returns. Sometimes it averts the decline altogether. And then there are rare instances, such as in 2022 when bonds dropped almost as much as stocks, that it lets the side down.
There’s another important feature of diversification that’s often overlooked: it eliminates the risk of capital loss. This is a bold statement, but history shows diversified portfolios always recover their losses given time. The same cannot be said for narrow strategies that focus on a handful of stocks of a particular type. To be clear, owning four Canadian bank stocks instead of one is not diversification.
Neither is owning thousands of stocks through myriad funds. That’s diworsification.
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Volatility refers to how dramatically a security, or the market overall, bounces around. A stock that’s up 20% one week and down 20% the next is volatile. One that trades in a narrow range is not. An emerging tech stock is volatile. A five-year Telus bond is not.
Confusion comes from how volatility relates to risk. Measures of bond, stock and interest rate volatility are used as inputs by banks, hedge funds and other financial firms in their risk-management models. They build strategies based on assumptions about expected volatility. For them, unanticipated downside volatility is a risk. It results in big losses.
For most long-term investors, however, volatility is not a risk. Sharp declines are disconcerting and cause anxiety (upward surges are celebrated), but it’s investment returns over 20-plus years that are important, not how smooth the journey is.
To build on what I said earlier, volatility is not a permanent loss of capital. It’s an opportunity to buy securities on sale or sell at prices you thought would take years to achieve.
Fees is a seemingly simple word that is open to a wide range of interpretations. It means different things to different investors and their advisers.
How often have you heard one of your friends say, “My guy charges me 1%.” That likely means his annual fee for trading, advice and administration is 1% of assets. There are taxes on top of that, and if he holds exchange-traded funds, mutual funds or other bank products, all of which have their own fees, the correct phrase is more likely, “My guy charges me somewhere between 1.5% and 2.5%.”
And then there’s, “I trade for free.” Well, no. The discount broker charges annual account fees, earns interest on your cash balance, gets commissions from the mutual funds you own, and, in most cases, is paid to flow your trades through a hedge fund that does high-frequency trading.
And, unfortunately, I hear this too often: “I have no idea what I’m paying, or what I’m entitled to.”
Giant investment firm Vanguard Group offers the best description for investment fees: “lost return.” It’s the total of all fees and charges that reduce how much you put in your pocket at the end of the day.
Unfortunately, I can’t clarify what fees mean to you. You’ll have to do some digging to determine how much return you’re losing for the service and expertise you’re receiving.