You've likely heard that your investment portfolio should be diversified, but you might not be sure what that means precisely, why it's important, and how to go about achieving it.
"By diversifying, you can divide your money across different asset classes, sectors, geographies and other types of investments," says Raquel Ferreira, senior financial advisor and mutual funds representative at Scotiabank. "It can help reduce risk because you aren't putting all your assets in one place."
There's no one single asset class, region, or industry that consistently outperforms, and the best and worst performers often changes from year to year. A diversified portfolio that includes stocks and bonds from a variety of industries, countries, and company sizes provides investors with more opportunity to participate in the growth potential of the financial market. Importantly, it also helps lessen the negative impact of investments that are underperforming so that you can worry less about day-to-day market fluctuations.
Here's what you need to know about achieving the right diversification mix to build towards your financial goals.
Why is diversifying your portfolio so important?
If your whole portfolio is in one type of asset, it will greatly affect your net worth if they have a downturn.
Not diversifying your investments may increase your risk, says Ferreira, "You become vulnerable to market fluctuations and economic downturns." A diversified portfolio means that your portfolio will likely experience less volatility and help keep you invested, which can help improve your long-term results as you save towards your goals.
4 ways to diversify your portfolio
Here are some of the common ways you can diversify your investments:
1. Types of investments
You can manage your risk by diversifying the types of investments you own. You should choose a variety of types of investments such as investing in different asset classes. You could spread out your investments in different types of assets like stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate, real estate investment trusts (REITs), guaranteed investment certificates (GICs), cash, and other types of investments — or to invest in mutual funds that invest in these types of assets for you.
Ensuring that you invest in a variety of different sectors and industries is key. Some Canadians think investing heavily in sectors that are growing significantly at the moment is the best investment strategy. While this approach could offer greater growth potential, it also comes with greater concentration risk, leaving your portfolio vulnerable to higher short-term volatility and market corrections. For that reason, it can be helpful to have your investments are spread out over multiple sectors.
Geographic diversification is about increasing your investment opportunities beyond the domestic market. For example, Canada (which is less than 5% of global stock market) is more heavily weighted in financial services and natural resources. Investing globally provides exposure to more companies and more sectors and industries.
4. Investment style diversification
Investment vehicles like mutual funds will often focus on a particular style of investing like value investing (which looks for stocks that are trading for less than their fair value), income investing (which focuses on investments that pay dividends or regular interest), and growth investing (which focuses on stocks that are expected to experience higher than average growth). Varying your investments across different styles adds an additional layer of diversification to help balance risk and enhance long-term return potential.
How to build a diversified portfolio
Now that you know why diversifying your portfolio is important, you might be wondering how you'll achieve it. Don't worry — you don't have to spend all your time researching and purchasing new investments. Luckily, there are some easy ways to diversify your portfolio so you can stop anxiously following the market's fluctuations and trust that your portfolio is on track for the long-term:
Mutual funds are investments that pool money from many investors to buy stocks, bonds, short-term money market instruments or other securities. You can choose the mutual funds that are the right fit for you. They diversify your risk by distributing your money over a range of securities, geographies, sectors, asset classes and more. This means that if one investment underperforms, that underperformance can potentially be made up by other investments in the fund's holdings.
Getting help from financial experts
Your financial advisor can work with you to create a personalized investment strategy that is based on your goals and risk tolerance to find the right solutions for you. That might involve a variety of saving and investing options like high interest savings accounts and GICs to mutual funds.
"An advisor can help you review several different options in detail and ask questions to better understand what type of investor you are," says Ferreira. "They can recommend a diversified approach that reflects your risk tolerance."
Rebalancing your portfolio routinely
Once you determine the right asset mix for your goal, time horizon and risk, inevitably some investments will perform better than others. This will cause your asset allocation to drift. Regularly rebalancing your portfolio back to your target asset allocation provides key benefits.
What is asset allocation?
Asset allocation is the strategy of dividing investments across different asset classes, such as stocks, bonds, and cash, in order to better protect your portfolio against the ups and downs of the markets.
If left unchecked, assets allocations that have performed well can grow to represent a larger percentage of your portfolio, which could introduce more risk than you're comfortable with. Selling the assets that performed will lock in gains and provide an opportunity to redirect the proceeds to assets that are underrepresented or have underperformed. This may sound counter intuitive, but market leadership rotates over time and the best and worst performers can change from one year to the next.
Finally, regular rebalancing can help keep your asset allocation on target and you on track to reaching your goals.
What's the best mix?
There is no one answer for what the best investment mix is for all investors. A portfolio that has invested in securities and a smaller amount of your funds invested in other types of investments can be diverse if it has geographic, industry, and investment style. Your ideal diversification strategy will also depend on your risk tolerance and time horizon. For example, a person with a three-year time horizon might invest primarily in lower risk investments like GICs and high interest savings accounts, whereas a person with a 30-year time horizon might invest primarily in higher risk investments with some lower risk investments to balance out their portfolio.
Diversifying can help you become a more confident investor
The number one reason to diversify your portfolio is because it helps you be less concerned about day-to-day market fluctuations.
"My clients who diversify their portfolios tend to be happier with their investments because they know that they're not exposed to just one market or one sector," says Ferreira. "When they start to see that their money is growing, they feel good that they've invested in different areas in the market."
Unsure what your ideal investment mix is? Talk to a Scotia advisor for help crafting your diversified investment strategy.