How diversification works
Under normal market conditions, diversificationDiversification A way of spreading investment risk by by choosing a mix of investments. The idea is that some investments will do well at times when others are not.+ read full definition is an effective way to reduce risk. If you hold just 1 investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition and it performs badly, you could lose all of your money. If you hold a diversified portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition with a variety of different investments, it’s much less likely that all of your investments will perform badly at the same time. The profitsProfits A financial gain for a person or company. Equals the money left over after you subtract your costs from the money you made.+ read full definition you earn on the investments that perform well offset the losses on those that perform poorly.
For example, bonds and stocks often move in opposite directions. When investors expect the economy to weaken and corporate profits to drop, stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition prices will likely fall. When this happens, central banks may cut interest rates to reduce borrowing costs and stimulate spending. This causes bondBond A kind of loan you make to the government or a company. They use the money to run their operations. In turn, you get back a set amount of interest once or twice a year. If you hold bonds until the maturity date, you will get all your money back as well. If you sell…+ read full definition 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. The reason for including bonds in a portfolio is not to increase returns but to reduce risk.
In theory, diversification enables you to reduce the risk of your portfolio without sacrificing potential returns. An efficient portfolio has the least possible risk for a given return. Once your portfolio has been fully diversified, you have to take on additional risk to earn a higher potential return on your portfolio. This chart shows the impact of diversification on a portfolio, and how risk changes when you seek higher potential returns.
4 reasons to diversify
- Not all types of investments perform well at the same time.
- Different types of investments are affected differently by world events and changes in economic factors such as interest rates, exchange rates and inflationInflation A rise in the cost of goods and services over a set period of time. This means a dollar can buy fewer goods over time. In most cases, inflation is measured by the Consumer Price Index.+ read full definition rates.
- Diversification enables you to build a portfolio whose risk is smaller than the combined risks of the individual securities.
- If your portfolio is not diversified, it will be unnecessarily risky. You will not earn a higher average return for accepting the unnecessary risk.
Consider different types of risk
When you investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition, you’re exposed to different types of risk. Learn how different risks can affect your investment returns and consider these risks when you diversify your portfolio.
Diversifying by asset class
One way to diversify your portfolio is to invest in several assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition classes. An asset classAsset class A group of securities that have similar characteristics. Examples of asset classes include, such as stocks, bonds, real estate or cash.+ read full definition is a group of investments with similar risk and return characteristics. The 3 main asset classes are:
- Cash and cash equivalents – like savings accounts, GICs and money market funds.
- Fixed incomeFixed income An investment that pays regular income to you. Examples: Guaranteed Investment Certificates, Canada Savings Bonds and types of other bonds.+ read full definition investments – like bonds, fixed income mutual funds and fixed income ETFs.
- EquitiesEquities Another word for investments in the stock market.+ read full definition – like stocks, equity mutual funds and equity ETFs.
Combining equities and fixed income investments within a portfolio helps to smooth out its returns because these asset classes have different risk and return characteristics. For example, the balanced portfolios in this interactive investing chart has 50% stocks and 50% bonds. The balanced portfolio returns are less volatile than the equityEquity Two meanings: 1. The part of investment you have paid for in cash. Example: you may have equity in a home or a business. 2. Investments in the stock market. Example: equity mutual funds.+ read full definition portfolio, and it is less likely to experience a big loss.
Use this chart to learn the risk characteristics of the main asset classes.
Diversifying by industry
You can diversify within an asset class, but simply increasing the number of stocks will not reduce risk. To diversify, you need to select stocks whose prices do not move together. Variations in the returns of one stock should offset variations in the returns of other stocks. Stocks within the same industry generally have prices that move together. Industries include:
- financial services (examples: banks, insurance companies)
- energy (examples: oil and gas, pipelines)
- materials (example: mining companies)
- industrials (examples: manufacturers, railways)
- consumer discretionary (examples: restaurants, hardware stores)
- telecommunication services (example: telephone companies)
- health care (example: pharmaceutical companies)
- consumer staples (examples: supermarkets, drugstores)
- information technology (example: wireless equipment companies)
- utilities (example: electricity companies)
For example, a portfolio initially consists of the shares of a bank. You add the shares of another bank. This will reduce the risk of the portfolio by very little because all banks are affected by the same economic conditions, like changes in interest rates. When the shares of a bank drop, those of other banks are likely to drop too. To diversify the portfolio, you could add the shares of companies from other industries, such as energy and health care.
Why diversification works
Each specific investment has specific risks. For example, if you invest in a car company that buys unique parts from a manufacturer in the Eurozone and the price of the Euro goes up in relation to the Canadian dollar, the company’s costs will rise and profits will fall. In this case, shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition prices may drop too. Other specific investments won’t be subject to the same risk at the same time. You reduce your overall risk by diversifying your portfolio.
Diversification in action
Use this chart to learn what happens to a stock portfolio’s total risk as you increase the number of stocks.
Similarly, you can diversify the bond portion of your portfolio by including a mix of bonds with different credit ratings and durations. This is effective because the values of bonds with strong credit ratings and those of bonds with weak credit ratings respond differently to changes in the economy. Similarly, bond values respond differently to changes in interest rates depending on their durationDuration Duration is a way to compare bonds with different interest rates and terms. It measures how sensitive a bonds price is to interest rate changes. It is stated in years.+ read full definition.
You evaluate the risk of a portfolio by looking at its volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition. When evaluating the risk of an individual investment, its own volatility does not matter. Instead, consider what the investment will do to the volatility of your portfolio. The portfolio’s volatility will be reduced if the investment’s returns do not move exactly in line with those of the portfolio.
The limits of diversification
A well-diversified portfolio provides reasonable protection under normal market conditions. Diversification works because, in general, asset prices do not move perfectly together. However, diversification becomes less effective in extreme market conditions. Generally conditions become extreme when something unexpected occurs. Examples are a market crash or government default. When this happens, markets can become illiquid and the prices of most investments drop.