Understanding diversification

Ever heard the expression “Don’t put all your eggs in one basket”? That’s diversification in a nutshell. It’s a risk-reduction strategy. If all your eggs are in one basket, you could lose all your eggs if something happens to the basket.

The same applies to your investment portfolio. With investing, diversification means owning a variety of investments with differing characteristics – asset class, industry, geography – to help lower your overall risk exposure to any one asset or group of assets.

What is diversification?

All investments carry some risk – but they don’t all carry the same risks. Different assets, different sectors, and different regions tend to perform differently in various market cycles.

Diversification can be an effective way to reduce your overall investment risk. If you hold just one investment and it performs badly, you could lose all or part of the money you invested. When you invest in a variety of assets, some may perform well, and some may perform poorly – but it’s less likely that they will all perform badly at the same time. What you earn on the investments that perform well can help to offset any losses on the investments that perform poorly.

Diversification by asset class

Asset allocation and diversification are closely linked concepts, but they’re not exactly the same thing. An asset allocation strategy establishes the relative proportions of equities, fixed income, and cash-based investments in your portfolio. Each of these asset categories (also called asset classes) have different levels of risk and different return potential, so an asset allocation strategy helps to manage risk versus reward over the long term.

Your asset allocation mix is personal to you because it must be appropriate to your tolerance for risk, time horizon and objectives. Basically, you aim to choose an asset allocation model calibrated to meet your goals, while exposing you to a level of risk you’re comfortable with.

Diversification by industry sector

To achieve diversification in your investment portfolio, you need to select investments that are less likely to be affected by the same economic or geopolitical factors. For example, stocks within the same industry sector are often affected by the same factors, their prices generally moving together. If your portfolio held only bank stocks, all your holdings would be similarly impacted by changes in the economic environment, such as interest rates. If one bank stock declines, the rest of them are likely to decline as well. Similarly, if you only held stocks in the energy sector, they are all likely to be affected by a drop in oil prices. If one energy stock declines, the rest of the sector is likely to decline too.

To diversify your investment portfolio, you could add stocks from other industries, such as health care, communication services, or industrials. Owning stocks from a variety of industry sectors helps to smooth out your risk as economic and other factors will likely impact each sector differently. If one or two sectors are down, other sectors could see gains that could help offset some of your losses.

Diversification by geography

Canada’s equity market represents just 3–4% of the world’s equities. And over two-thirds of Canada’s equity market is concentrated in just three of the world’s 10 major sectors: financials, energy, and materials. So, by default, a portfolio of Canadian stocks is heavily weighted in those three sectors. Investing in different regions of the world exposes your portfolio to broader opportunities while helping mitigate the risks associated with investing in a single country or region.

Diversification by market capitalization

Market capitalization is another way to diversify equity investments. A company’s market capitalization measures its overall value. It helps investors understand a company’s size, financial scope, and how its value is perceived by the market. Most companies are categorized as:

• Small-cap (companies with a market cap between $250 million and $2 billion)
• Mid-cap (companies with a market cap between $2 billion and $10 billion)
• Large-cap (companies with a market cap of $10 billion or more)

A company’s market capitalization usually corresponds to the stage of its business development. The smaller its market capitalization, usually the earlier it is in its cycle, which means it may offer significant long-term growth potential. However, because it’s earlier in its development, it may be more vulnerable to a change in the business environment or competitive pressures. A large-cap company is generally more established, and often perceived to have less risk. However, a large-cap company’s growth potential may be lower than a company that is earlier in its development.

How to add diversification to your portfolio

Diversification can be achieved by purchasing investments in different asset classes, within different countries, industries, and market capitalization. If you’re investing in fixed income securities, diversification could mean investing in different industries, issuers, and term lengths.

A relatively simply way to diversify your portfolio is to add diversification through mutual funds or exchange-traded funds (ETFs). Since each mutual fund or ETF holds a basket of underlying securities, they provide much more diversification than a single stock. And some funds are more diversified than others depending on what type of fund it is (most focus on a specific area of the market, such as stocks or bonds, as well as specific sectors, geographies or market caps).

How Qtrade can help

The value of a diversified investment portfolios cannot be overstated. A more diversified portfolio can help you minimize your investment risk and even out your returns.

Qtrade Direct Investing’s Portfolio Score lets you evaluate the various risk exposures in your existing portfolio. This scoring tool gives you a breakdown of your average correlation across asset class, geography, sector and macroeconomic factors. Each of these dimensions can help illustrate where your portfolio could benefit from greater diversification.

^{The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.}