One way to help reduce the risk of your investment portfolio is through diversification. Diversification doesn’t necessarily make you more money or stop you from losing money; it simply means not putting all of your eggs in one basket.
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 in the same way.
So what does a diversified portfolio look like?
In a diversified portfolio, you hold different types of investments so that if there is a downturn in some investment categories, you have other ones that can help cushion the impact. Therefore, the asset mix you choose is important to the overall risk and expected returns of your portfolio.
There are three basic categories of investment products or asset classes:
- Equity investments, which are ownership shares in a company, and are commonly known as stocks or shares.
- Fixed-income investments, which pay you predetermined interest or dividend income, such as government and corporate bonds.
- Cash or cash equivalents, which are investments that can quickly be converted to cash with little risk, such as a typical savings account or GICs.
Your asset mix will largely determine the risk and expected return of your portfolio.
The right asset mix can help balance risk with your expected rate of return on your investments. It should fit your risk tolerance, let you get money when you need it, and help provide the growth you need to reach your financial goal.
Your asset mix may change as your financial needs and goals change overtime.
To diversify, investors select assets whose prices do not move together. Variations in the returns of one asset should offset variations in the returns of other assets.
For example, an investor might have a portfolio that consists of the shares of a bank and decide to add the shares of another bank.
This won’t reduce the risk of the portfolio by much because banks are affected by the same economic conditions, like changes in interest rates.
To diversify this portfolio, the investor could add the shares of a variety of companies from other industries, such as energy, technology, or healthcare.
Liquidity also plays an important role in diversification. Liquidity refers to how quickly you can turn your investment into cash. A liquid investment, such as one traded on a stock exchange, can be sold rapidly at its asking price anytime within market hours.
If your asset is illiquid, you may have to hold on to it even as it loses value, accept a lower price than you had planned, or you may not be able to sell it at all.
As with any investment strategy, there are limits to diversification. A well-diversified portfolio provides reasonable protection under normal market conditions. Diversification works because, in general, asset prices do not move perfectly together. But diversification may be less effective in volatile or unique market conditions.
Remember, as your financial goals and needs change overtime, you will likely want to review – and possibly change – your asset mix in order to improve the diversification of your investment portfolio.
Contact the BC Securities Commission for more information.