Investing often invokes fear. No one wants to make a costly mistake, especially when the stakes are high – as they are for retirement savings.
That’s why a cardinal rule when it comes to successful investing is to diversify your portfolio.
When you diversify your investments, you’re managing downside risk by spreading a pool of money across different types of asset classes (stocks, bonds, cash-equivalents, commodities) as well as different types of securities within those asset classes (Canadian dividend stocks, small-cap technology stocks, global corporate bonds, etc.).
DIVERSIFICATION HELPS MANAGE RISK
Not even the smartest stock market strategists can predict where the markets are headed. Sure, anyone can make the right calls occasionally, but there are lots of factors that can affect the performance of assets – most of which we can’t possibly foresee.
For instance, stocks tend to outperform bonds when the economy is growing. But when economic growth stalls, bonds usually do better than stocks. And since no two company stocks or bonds are the same, they’ll also react differently to certain events.
Take inflation for example. Real estate often slumps during periods of rising inflation rates, while gold is seen as a hedge against inflation. By owning both, you have a better chance of riding out the near-term volatility.
Will your gains from some investments outweigh losses from others? By building a diversified portfolio that invests across and within asset classes, you spread your risk and give your overall portfolio a better chance to grow.
WHAT TO CONSIDER WHEN YOU DIVERSIFY
Whether you’re reviewing your portfolio or starting from scratch, here are a few things to keep in mind:
Your Risk Tolerance
How comfortable you are with volatility and potentially losing money on your investments? Understand your risk tolerance and diversify your investments accordingly.
Fortunately, there are a myriad of investments that vary in risk and that means you have a lot of options. You can choose a mutual fund that matches your risk tolerance or a mix of funds that, combined, are close to your risk tolerance. If you’re more risk averse and require income, you can create a portfolio that leans towards fixed income assets with some exposure to well-established defensive stocks.
The possibilities are endless. What’s important is that your overall portfolio is set up to align with your risk tolerance (rather than every single individual security).
Your Investment Pool
It’s hard to diversify when you don’t have a large pool of money to invest. That’s because there are “minimums” to purchasing certain types of assets. For instance, to maximize the benefits of diversification, you would need to invest in 12-18 different stocks. With minimum investment requirements, that could mean deploying tens of thousands of dollars.
If your investment pool is small, mutual funds and exchange-traded funds (ETFs) can be a cost-effective way to diversify. Mutual funds and ETFs are both investment vehicles that pool money from numerous individuals to buy various assets or securities.
IS IT POSSIBLE TO OVER-DIVERSIFY?
Diversification is important, but it is possible to overdo it. To avoid over-diversifying, keep your investment portfolio manageable. Having too many individual stocks to monitor is a sign you may be over-diversifying. Another sign is having too many mutual funds that seek to do the same thing – such as investing in a certain region or sector or with a similar investment style.
Now that you’ve learned the importance of diversification, carve some time out to review your portfolio to ensure you’re comfortable with your investing strategy. Better yet, set up time with your advisor to review your portfolio.
Book a twenty-minute meeting with Karen Sill, manager of Financial Planning at Lawyers Financial, and get started with a complimentary financial plan.
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By Saijal Patel, financial-wellness advocate and founder of Saij Elle.