Diversification 101

In the world of investing, one thing is certain – markets will go up and down as economies move through different cycles of growth, taking investor emotions along with them. Managing such emotions, at both the peaks and valleys of the market, is one of the hallmarks of successful investors. Whatever happens in the market, a diversified portfolio can help prepare you to stay focused on the long term, knowing that your money is working for you.

Diversification means holding various types of investments in your portfolio. When choosing how to diversify, start with your investor profile. The appropriate mix of the basic asset classes – cash, fixed income and equities will depend on your investment objective and other factors such as time horizon and comfort with volatility. Within each asset class, each investment can act as a building block with the objective of creating a portfolio with a solid foundation.

  • Cash and cash equivalent investments can provide you with a stable base for your portfolio and easy access to cash to tap into on short notice. One potential drawback –  returns may not keep up with inflation. 
  • Fixed Income investments generate cash flow and can provide some stability to your portfolio. Can be sensitive to movements in interest rates.
  • Equity investments provide the greatest potential for long-term growth along with a higher degree of risk.

A well-diversified portfolio

Financial markets do not typically move in concert with one another. In addition, no one can reliably predict how a particular asset class will perform in any given year. One asset class may be leading the market while others lag and it may be completely different the next year.

While historic returns do not predict future performance, the table below shows relative performance of some of the more popular asset classes in Canada over the past 10 years. As you can see, there were years when equities led market returns and years when fixed income led the market. There were also periods when a market leader from one year underperformed all of the other asset classes the following year, and times when the lowest performer from one year went on to lead the market the next year.

As markets will always fluctuate, investing in a number of investments in a diversified mix of equities, fixed income and cash may help protect your portfolio from a decline in value. The concept behind diversification is that assets that are increasing in value can work toward compensating for others that may be decreasing. This can help to reduce the overall risk in your portfolio and smooth out returns over time.

More ways to diversify

Various methods are used by investors to diversify their portfolios including by:

  • Geography: diversifying assets globally can help to reduce the risk of being exposed to any single country and can give you access to opportunities not available in Canada.
  • Economic sector: By holding investments across a broad range of industries, you can protect your portfolio from downturns in any one sector.
  • Number and concentration of holdings: A larger, more diverse number of investments with less concentration in any one holding, can reduce a portfolio’s exposure to company-specific risks.
  • Management style: Diversifying by management style can help smooth portfolio returns as different management styles react uniquely to market conditions.
  • Market capitalization: Diversifying by size – small-cap, mid-cap, or large-cap companies – can provide you with a range of investments with exposure to broad market opportunities.
  • Alternative investments: Many investments fall under this category because they do not typically move in sync with traditional asset classes. Examples include real estate investment trusts (REITs), structured products, precious metals and more.

Source: RBC Direct Investing

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