Investing 101: What is Diversification?
Diversification means holding different types of investments.
This article explains the basics of diversification and how to work with a registered investment advisor to build a portfolio.
Holding different investments does not mean a portfolio is diversified; diversification is about balancing risk and return so that the portfolio fits your financial goals and risk tolerance.
A registered advisor can help investors understand diversification and assess the level of risk in a portfolio needed to provide target returns.
Choose the Right Asset Mix
Understanding how different assets work together in a portfolio is key to realizing the benefits of diversification.
The asset mix is how money is allocated across different asset classes, such as:
- Fixed income
- Cash or cash equivalents
Depending on your risk tolerance and goals, the asset mix balances the level of risk and return.
Registered investment advisors follow prescribed steps to understand who you are as an investor (called the Know-Your-Client rule) and find an asset mix that works for you. Registered advisors cannot recommend products that are not suitable for your financial situation and risk profile.
Examples of Diversification and Asset Mix
The best way to understand diversification is to think about it in terms of an actual investment portfolio.
Imagine you are a growth investor with a high tolerance for risk. In this case, an advisor may recommend holding a large portion of your investments in equities (stocks). This means you would own fewer fixed income investments and cash compared to a more risk-averse investor. Most of the returns in this hypothetical portfolio will come from the price of the stocks going up.
In practice, diversification is more than just buying shares of different companies. It can involve mathematical equations and problem solving to ensure buying one stock or fund offsets the risk in another without sacrificing too much of the returns.
Investment Funds and Diversification
Investment funds like mutual funds and exchange-traded funds (ETFs) offer some level of diversification, depending on what the fund holds. A registered advisor can help investors understand how a specific fund may or may not diversify their investments.
For most investors, funds can provide access to a broad range of investments for a reasonable price. Over time, these holdings can be easier to manage and less risky than trading individual stocks.
Investment funds typically hold a mix of investment types, including:
- Stocks and equities
- Bonds and fixed income
- Units of other investment funds (also known as fund-of-funds)
- Alternative investments (derivatives, real estate-based securities, promissory notes, and other high-risk investments)
Mutual funds, ETFs, and other funds have distinct features and risk levels. Visit the Investment Funds page to learn about these differences.
Know Your Registered Investment Advisor
In looking to diversify a portfolio, you may need to speak with a registered investment advisor.
A good working relationship with an investment advisor will go a long way in helping to achieve your financial goals. Therefore, it’s important to research an advisor’s qualifications, registration, and work experience.
A few items to consider when working with an advisor include:
- Who’s responsible for what when it comes to investing your money
- Titles and designations in the financial services industry
- Understanding registration and searching for disciplinary history
- How advisors are compensated
Learn More about the Basics of Investing
BCSC InvestRight has tools and information to help you learn more about investing. The Investing 101 section of our website covers topics like:
- Buying and Selling Investments
- Return on Investment
- Fees & Charges
- Types of Investments and Types of Accounts
If you have any concerns about a person or company offering an investment opportunity, please contact BCSC Inquiries at 604-899-6854 or 1-800-373-6393 or through e-mail at [email protected] You can also file a complaint or submit a tip anonymously using the BCSC’s online complaint form.
InvestRight.org is the British Columbia Securities Commission’s investor education website.