Diversification is a strategy that spreads your risk over different types of investments, so you balance both the overall risk and your potential returns. By diversifying, you also help protect your savings from the market’s ups and downs, since different types of investments, such as stocks and bonds, often move in different directions. You can diversify by investment type (fund class) and by levels of risk within investment types, such as by choosing investments in different regions or with different management styles.
How does diversification reduce your investment risk?
If you hold just one type of investment and it performs badly, you could lose a lot of money. But if you hold many different kinds of investments, the theory is that it’s unlikely all your investments will perform badly at the same time. The return you get on the investments that perform well could balance out some of the losses on those that don’t do so well.
How to invest at any age
- Just beginning your career? With retirement decades away, you have time on your side. You can increase your portfolio’s long-term investment risk and set yourself up for higher potential returns.
- Midway through your career? Retirement is still years away, so you can make the most of the time you have to grow your investments with a moderate increase in the long-term investment portion of your portfolio.
- Getting close to retirement? With retirement only a few years away, it makes sense to align your portfolio with your retirement income goals by diminishing investment risk and potentially providing higher returns. A diversified portfolio can help ensure you’re closer to your dreams. (Read more: How to save for a debt-free retirement.)
To see how much you will have saved by the time you retire, based on your current plan, use this retirement savings calculator.
How much investment risk should you take?
Different investment types, or types of funds, have different purposes and varying levels of risk and potential return:
- Lower-risk investment portfolio: Cash equivalents, such as money market funds, provide low-risk returns and generally include investments such as guaranteed funds and short-term deposits that pay you interest. While the risk is low, many cash equivalents also have low rates of return. (Looking for steady investment return with less risk?)
- Medium-risk investment portfolio: Fixed-income investments, such as bonds, are generally higher risk than cash equivalents, but offer potentially higher returns. When you invest in bond funds, you lend money to the company or government issuing the bond. Over a specified time period, that company or government repays the amount of the loan plus interest. Bond fund values go down when interest rates go up, and vice-versa. (Should you buy bonds or bond funds?)
- Higher-risk investment portfolio: Equity funds are made up of stocks, which are considered to be of higher risk than cash equivalents or fixed-income investments. But with higher risk comes a higher potential for long-term growth. Equity funds give you an ownership interest (a share) in the issuing companies. An increase in the value of a company translates into investment gains. (Which investments can reduce your tax bill?)
How to diversify your investments
Diversifying within an investment type means choosing investments in the same category that could react differently to the same event (such as an interest-rate spike or a political crisis). By diversifying by region and management style, you balance your overall investment volatility – losses in one area may be offset by gains in another.
Explore new regions. Diversifying by region means investing not only in Canadian funds, but also in foreign funds. This increases your chances of growth while managing risk. You benefit from the strength of different markets, while reducing the risks of having all your investments tied to just one region.
Mix up management styles. Managers apply varying investment styles when choosing underlying stocks for their funds. Different styles perform well in different economic cycles and environments. No single management style consistently outperforms the rest. Common styles include:
- Active fund managers, who choose funds using analytical research, forecasts and their own judgment.
- Passive or index fund managers, who buy and sell assets of a fund to match the characteristics of an index (such as the S&P/TSX Composite).
- Growth fund managers, who invest in companies experiencing a rapid growth in profits.
- Growth at a reasonable price (GARP) managers, who look for stocks of growth companies they can buy for a reasonable price.
- Value fund managers, who buy stocks of companies they believe are undervalued by the market.
- Bottom-up managers, who focus first on the fundamentals of a company before looking “up” at other factors, such as the economy.
- Top-down managers, who examine an industry’s broad economic outlook before looking “down” to select individual stocks from that industry.
It’s important to keep sight of your long-term goals, and diversification will help you achieve those targets. You may want to speak with a qualified financial professional about what level of risk is right for you and how to diversify your portfolio.
- Need help with your investment portfolio? Find an advisor near you.