Portfolio diversification strategies

Diversification is the practice of holding investments with a variety of different attributes. The idea is to limit risk and avoid letting a single asset or asset class drag down your entire savings. Being diversified can help to reduce your overall risk and manage volatility within your portfolio. Historically, it has been shown to be an effective strategy to help grow your wealth.

A portfolio made up of a single stock has the potential to be extremely volatile. For example, if you only invest in one company and it suffers a lawsuit or loses major customers, it could cause the stock price to decline, causing your savings to plunge. Although concentrating investments into a single stock can also work in your favour — say if that same company won new business — the upside risk to your savings could be significant.

In contrast, the more diversified your portfolio is, the more stable it could become. A portfolio that holds many stocks as well as a mix of asset classes, such as stock and bonds, increases the chance you may benefit from exposure to better-performing investment types at any one time, while minimizing the impact of any one underperforming investment.

Diversification is considered highly important because it can help decrease your risk while still allowing you to grow your portfolio. If your portfolio is broadly allocated, you minimize the chance of losing money, adjusted for inflation, between now and when you ultimately begin drawing down your savings.

Some investors may suffer from "home-country bias" when choosing investments — for example, buying shares in companies they know that operate in their own nation. That can leave investors vulnerable to localized economic downturns, currency devaluations and political risk in their own country. It can also limit choice. The Canadian market, for example, has a higher concentration of energy and financial stocks than many other countries. Canada also accounts for less than 5% of the global investible universe, which means you may miss out on some good businesses by only investing in Canadian firms. To reduce concentration risks, some investors may consider owning stocks and bonds from regions around the world.

Companies in certain industries may outperform those in industries facing different economic conditions or stages of the business cycle. As an example, a sector that uses a lot of leverage or borrowing to invest, such as real estate, could benefit when interest rates are low, but suffer as rates rise. Having exposure to several major sectors could reduce the impact of a single sector pulling down a portfolio.

Some do-it-yourself investors may adopt styles or methodologies to help them select the stocks they want to own. For example, growth investors screen for companies whose revenues or earnings are trending higher. Value investors, by comparison, seek out stocks that appear to be selling at a lower price than their peers by various valuation metrics. Though these and other styles can be effective at boosting returns, certain styles may outperform others at any one time, a reason why some investors employ more than one in managing your portfolio.

How you invest and diversify your holdings could depend on several different factors, including your comfort with risk. An important consideration is how soon you will need the money for each of your goals. When you have a longer time horizon, you may be in a position to invest in riskier assets that offer a higher potential for return, such as stocks, as you will have more time to recover any losses. As you get closer to your goals, less volatile assets such as bonds may be more prudent to help preserve your capital.

Some investors may consider investing in so-called alternative asset classes, that have the potential to hold or increase their value when mainstream securities tank. Some of these assets could include an investment property, precious metals or cryptocurrency. Some alternative assets may appeal more broadly to middle- and high-income investors who already have substantial stock and bond holdings. This can be true in the case of more sophisticated classes like private equity and hedge funds, which can require minimum investments and require you to lock in your funds. 

Exposure to a wide range of assets can increase the likelihood you will benefit from the unpredictable outperformance of any one investment or set of investments. For example, if U.S. tech stocks post big gains, you could benefit. Conversely, if long-term bonds rebound, you’ll also benefit.

The fluctuation of asset values can be psychologically painful to many investors and financially harmful to those who need to draw down their holdings, such as retirees. Diversification can help to smooth out the markets’ roughest edges.

By holding a mix of investments for short-medium- and long-term purposes, it could help to ensure you have assets that can be sold, if necessary, on short notice. Longer-term holdings may sacrifice liquidity in return for either guaranteed or higher potential returns.

A diversified portfolio can be designed to suit all kinds of goals — from providing income in retirement income to funding a child’s wedding — while remaining sensitive to your financial personality and risk tolerance.

Here are some tasks involved in building and maintaining a diversified portfolio.

Diversification benefits arise from holding investments whose performance is not highly correlated. For example: A portfolio 100% invested in equities will be vulnerable to stock-market crashes that historically have taken as much as 50% of investors’ capital. By diversifying into uncorrelated assets, such as cash instruments (Guaranteed Investment Certificates (GICs), high-interest savings accounts), or negatively correlated assets (such as bonds) you may be able to limit the risk of extensive losses.

Because your varying investments will perform at different paces, the allocation values to your many asset classes and sectors in your portfolio can fluctuate out of alignment with your investment plan. For example, if you aim to have a 50-50 portfolio of stocks and bonds, and stock markets rise significantly in one year, you could end up with 70% of your assets in stocks. As a consequence, this could make your portfolio riskier than intended. It is important that you reassess your portfolio and rebalance as required — one way can be selling some overachievers and buying slower growers — every year or even every six months. It can help you to lock in gains on strong performers and get your risk levels back to where you want them.

You never know how your investments may perform in the future, but you can foresee how much of your returns will be offset by trading and portfolio management fees. Tracking and, where possible, keeping your costs low, can optimize your gains over time.

Your investment mix should match its ultimate purpose. A post-secondary education savings plan, for example, might typically become more conservative as your child approaches high school graduation.

You can enhance the potential for returns or reduce risk with tactical changes to a portfolio. After a market crash may be a time to consider increasing your exposure to stocks as they recover. It may also be prudent to hold bonds when interest rates appear set to fall. Timing the markets is notoriously difficult, however, which another reason to hold multiple asset classes at once, making adjustments as you see fit.

You may be aware of “balanced” mutual funds and “asset allocation” Exchange-Traded Funds (ETFs) that hold Canadian, U.S. and international stocks as well as bonds in a single package. These investments may offer a pre-set package of investments that is regularly rebalanced — either passively or actively on your behalf, for the cost of a management expense fee. Many of these instruments can be bought by anyone with a brokerage account.

You can think about diversification right from the start. A downturn can happen at any time, so there may be no time like the present to start protecting your portfolio.

One common diversification strategy is to allocate roughly 60% of your portfolio to equities and the other 40% to fixed income. This is often described as a balanced portfolio, combining the long-term returns of stocks with the greater stability of bonds. Depending on your time horizon, investing personality, financial resources and market conditions, you may choose to deviate from that balance or add alternative assets. Over time, your portfolio will naturally drift from your initial mix, requiring you to periodically rebalance your holdings.

The easiest way to diversify is to hold funds invested in a range of stocks and bonds. If you have a brokerage account, you can buy fully diversified, low-cost ETFs, such as TD ETF Portfolios.

Yes. Risk management is a key benefit of diversification.

Yes. Diversification can help to ensure you don’t miss out on the outperformance of any one type of investment. 

Diversification helps ensure part of your portfolio is allocated to liquid investments that can be sold on short notice without incurring losses.

Diversification can help to both preserve your capital and achieve long-term growth.

Diversification can provide exposure to different asset classes, helping to ensure you are not overly exposed to investments that experience larger-than-expected losses, keeping in mind that you would need to reassess and rebalance as required.