Diversification is an investing strategy that helps you manage your exposure to risk by spreading your investments across different assets. If you invest in just one type of asset, your entire investment is tied to the performance of that single asset. If you hold a diversified portfolio with a variety of different investments that are not correlated, the individual investments should perform differently, balancing out the risk in your portfolio.
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What is diversification?
Diversification is an investing strategy that helps you manage your exposure to risk by spreading your investments across different assets.
If you invest in just one type of asset, your entire investment is tied to the performance of that single asset. If you hold a diversified portfolio with a variety of different investments that are not correlated, the individual investments should perform differently, balancing out the risk in your portfolio. Ideally, the profits you earn on investments that perform well will offset the losses of poorly performing investments.
For example, when markets are affected by inflation, bonds and stocks often respond differently. During periods of high inflation, central banks may cut interest rates to reduce borrowing costs and stimulate spending. This causes bond prices to rise. However, stock prices may weaken in sectors of the economy negatively affected by inflationary price increases. In this example, 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.
What are the advantages of diversifying your portfolio?
A diversified portfolio has the least possible risk for a given return. There are a few good reasons to diversify your portfolio, such as:
- 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 inflation rates.
- You can build a portfolio with lower risk than the combined risks of the individual securities.
Consider different types of risk. When you invest, 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.
How can you diversify your portfolio?
There are many ways to diversify your portfolio, including by asset class, industry or country.
1. Diversifying by asset class
An asset class is a group of investments with similar risk and return characteristics. Diversification across asset classes is a common strategy to mitigate risk, since different asset classes tend to respond differently to changes in the market. The three main asset classes are:
- Cash and cash equivalents – Such as savings accounts, GICs and money market funds.
- Fixed income investments – Including bonds, fixed income mutual funds and fixed income ETFs.
- Equities – Like stocks, equity mutual funds and equity ETFs.
Cash and cash equivalent investments such as Guaranteed investment certificates (GICs) tend to offer relatively low rates of return compared to the potential returns from equities or fixed income investments. However, they can be more beneficial investments for short-term goals because they are relatively stable compared to other asset classes that are more volatile during market swings.
Equities and fixed income investments have different risk and return characteristics. For example, a balanced portfolio with half stocks and half bonds is less volatile and less likely to experience a large sharp loss, than a portfolio that is all stocks. The balanced portfolio returns are less volatile than the equity portfolio, and less likely to experience a big loss.
How much of your portfolio you dedicate to each asset class will depend on your risk tolerance, and whether your investing goals are more short-term or long-term. Consider speaking with a financial advisor to build a portfolio that works for your situation.
2. Diversifying stocks by industry
While diversifying asset classes can be helpful, it’s also important to diversify within asset classes. This means considering not just how much of your portfolio is dedicated to stocks, but the type of stocks you hold among different industries. This is useful because stocks from different industries don’t tend to all respond to the market in the same way. Variations in the returns of one stock could offset variations in the returns of others.
Stocks within the same industry generally have prices that move together. Industries include:
- financial services (banks, insurance companies)
- energy (oil and gas, pipelines)
- materials (mining companies)
- industrials (manufacturers, railways)
- consumer discretionary (restaurants, hardware stores)
- telecommunication services (telephone companies)
- health care (pharmaceutical companies)
- consumer staples (supermarkets, drugstores)
- information technology (wireless equipment companies)
- utilities (electricity companies)
Consider a portfolio consisting of the shares of one bank — an investment in the financial services sector. If you add shares of another bank, you have not changed the industry diversification of your portfolio. This means that both shares are likely to be affected by market fluctuations in the same way. When the shares of a bank drop, other bank shares are likely to drop too. To diversify the portfolio, you could add the shares of companies from other industries.
3. Diversifying bonds by credit rating or duration
Similar to diversifying equity investments by industry, you can diversify the bond portion of your portfolio by including a mix of bonds with different credit ratings and durations. This can be 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 duration.
4. International diversification
You can diversify your investments by considering the markets they are based in. For example, when investing in equities you could consider the United States, Canada, and international markets. If you focussed only on Canadian investments, your portfolio could become over-weighted in the resource and financial sectors. Investing in different international markets can provide exposure to additional market sectors that may be unavailable in Canada. Large markets, like the U.S., can also provide global exposure due to the higher number of large multi-national companies headquartered there.
There are generally three types of markets to choose from when thinking about international diversification:
- Developed market – A country with well-developed capital markets and economy.
- Emerging market – A country that does not have as well-developed an economy or capital markets when compared to a country in the developed market. Emerging market countries may be riskier than developed market countries.
- Frontier market – A country that has signs of development but cannot be considered an emerging market. Frontier markets tend to carry the highest investment risk.
Because risk and return are related, investing in emerging and frontier markets may expose investors to a higher potential rate of return — but also bigger potential losses — compared to investing in the developed market.
What are some of the risks of international diversification?
All investing comes with certain amounts of investment risk. Here are a few things to keep in mind if you are investing outside of Canada:
- Emerging market risk – The risk of loss when investing in emerging market countries which may be less stable economically or politically. When you invest in shares of companies in emerging markets there may be risk such not being able to sell your investment quickly — liquidity risk — or the risk of sharp loss in the value of your investment due to potential economic crisis.
- Currency risk – The risk of losing money because of a movement in the exchange rate. If you invest in a stock in foreign currency, you will have to convert it back into your own currency when you sell the investment. If the value of the foreign currency has declined, this could harm your rate of return at the time you sell.
- Political risk – The risk of loss when there are changes to the political leaders or policies in a country. For example, if a new government comes into power, it may decide to make new policies. Sometimes these changes can be seen as good for business, and sometimes not. They may lead to changes in inflation and interest rates, which in turn may affect stock prices. An act of terrorism can also lead to a downturn in economic activity and a fall in stock prices.
- Credit risk – The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity.
It’s important to keep in mind how your foreign investments are taxed. If you receive interest, dividends or capital gains from investments outside Canada, the equivalent Canadian dollar value must be reported on your Canadian tax return and will be taxed accordingly. Interest and investment income are usually shown on T5, T3, and T5013 slips. Foreign dividends do not qualify for the federal dividend tax credit. Learn more about reporting foreign income on your tax return.
What are the limits of portfolio diversification?
A well-diversified portfolio provides reasonable protection under normal market conditions. Diversification works because, in general, asset prices do not move perfectly together. Provided all sectors of the economy are not affected by the same market conditions, a diversified portfolio would mitigate risks.
However, diversification becomes less effective in extreme market conditions. Generally, conditions become extreme when something unexpected occurs, such as a market crash or a government default. More recent examples of this would be the 2008 financial crisis, or the 2020 COVID-19 pandemic. When a market crash happens, markets can become illiquid, and the prices of most investments drop.
You can’t completely eliminate investment risk from your portfolio, but diversification can help reduce it. Extreme events like market crashes can’t always be predicted, but they are recurring events that are part of the investing landscape. Historically, markets have recovered from market crashes, but this can often take months or even several years. See the impact of markets up and downs over time with Investing Charts.
If you’re unsure about how to navigate portfolio diversification or potential market swings, consider working with an advisor. They can support your investing goals within the level of risk that is comfortable for you.
Summary
Diversification is an investing strategy that spreads your investments across and within different asset classes. Keep in mind:
- Diversification is a way to mitigate how much risk your portfolio is exposed to.
- You can’t eliminate risk from your portfolio, but diversification can help reduce it.
- There are a few ways you can approach investing diversification, including by asset class, by industry, and by international markets.
- During extreme market conditions such as a market crash, diversified portfolios can still experience loss.
- If you’re unsure about how to manage diversification, consider working with a financial advisor.
