Step 4 to investing is choosing your asset mix. To choose the right asset mix, it's important to understand the concept of diversification.
Diversification is a way to try to reduce risk by choosing a mix of investments. With a diversified portfolio, you spread your money across different types of investments (or asset classes). The 3 main asset classes are:
- Cash and cash equivalents – like savings accounts, GICs and money market funds.
- Fixed income investments – like bonds and fixed income mutual funds.
- Equities – like stocks, equity mutual funds and ETFs.
How diversification works
Under normal market conditions, diversification is an effective way to balance risk and return. If you hold just 1 type of investment and it performs badly, you may lose everything. If you hold many types of investments, it’s much less likely that all of your investments will perform badly at the same time. The return you earn on the investments that perform well could offset some of the losses on those that perform poorly.
For example, fixed income investments and equities often move in opposite directions. When investors expect the economy to weaken and corporate profits to drop, stock prices will likely fall. When this happens, central banks may cut interest rates to reduce borrowing costs and stimulate spending. This causes bond prices to rise. If your portfolio includes both stocks and bonds, the increase in the value of bonds may help offset the decrease in the value of stocks.
Diversifying within asset classes
There are ways to diversify within asset classes, too. For example, try not to hold all of your stocks in just 1 industry sector, such as banks or technology. That’s because different sectors respond differently to changes in the economy, and some sectors are riskier than others.
Within your bond holdings, you may want to diversify by choosing bonds with different credit ratings and terms to maturity.
4 reasons to diversify
- Not all types of investments perform well at the same time.
- Different types of investments react differently to world events, interest rates and other factors in the economy.
- When 1 type of investment is down, another may be up.
- Having a mix of different types of investments may help smooth out your returns.