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How diversification works
Under normal market conditions, diversification is an effective way to reduce risk. If you hold just one investment and it performs badly, you could lose all of your money. If you hold a diversified portfolio with a variety of different investments, it’s much less likely that all of your investments will perform badly at the same time. The profits 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, 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. 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.
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 inflation 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 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.
Diversifying by asset class
One way to diversify your portfolio is to invest in several asset classes. An asset class 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 income investments – like bonds, fixed income mutual funds and fixed income ETFs.
- Equities – 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 equity portfolio, and it is less likely to experience a big loss.
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, share 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.
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 duration.
You evaluate the risk of a portfolio by looking at its volatility. 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.
