Lesson 3: Diversify your portfolio

A traditional investment portfolio will typically hold investments from different asset classes. An asset class is a group of investments with similar characteristics that behave similarly in financial markets. The main financial asset classes are stocks; fixed income — also called bonds; cash and cash equivalents; real estate; and commodities such as precious metals, oil, etc.

Diversification is a strategy that spreads your investment dollars across a variety of different asset classes to reduce overall risk. The variety of investments can allow your portfolio to benefit under many different economic conditions and phases.

In this article, we’ll focus on the three asset classes that you can access through an Investor’s Edge account: stocks, fixed income and cash equivalents.

A classic investment portfolio holds three main asset classes in different percentages: stocks, bonds and cash. Each asset class is associated with a different amount of predicted risk and a different predicted return. Generally, your time horizon and risk tolerance will guide how much you’ll commit to each class.

Stocks, also known as equities

Stocks, or equities, allow you to own a piece of a company and benefit from its potential growth and profitability. Stocks have historically provided the strongest long-term returns of the main asset classes, but they can be volatile, especially in a slowing economy. In this asset class we can also include Exchange-Traded Funds (ETFs) and Canadian Depositary Receipts (CDRs), which provide other ways to invest in stocks.

Fixed income, also known as bonds

Fixed income investments, or bonds, are units of debt issued by governments, corporations or other institutions. Fixed income typically offers more moderate returns but less volatility when compared to equities.

Cash and cash equivalents

Cash and cash equivalents are the most liquid assets, meaning the assets that can be quickly accessed without a loss in value. They offer lower returns along with the least amount of risk.

In a strong economy, corporate profits typically rise, and stocks tend to perform well compared to fixed income. But when the economy slows and companies begin to struggle, the stock market may decline. In a slowing economy, bonds may start to look relatively more attractive. Bonds provide some investment return with a guarantee of getting your money back if you hold the bond until it matures — the relatively rare exceptions are bond defaults.

Having both stocks and bonds in an investment portfolio can add resilience against the market ups and downs that result from the economic cycle. It also makes it psychologically easier to stay committed to an investment plan, as some parts of the portfolio will likely be less volatile when markets fluctuate dramatically. For many investors, this is reassuring.

Within each asset class, it’s also a good idea to diversify even further. Let’s say you invest all your money in a single stock, such as a technology company. If that company has a bad year, your entire portfolio takes a hit. If you instead spread your investments across several different industries such as tech, energy and retail, you’ll likely reduce your risk. If one industry takes a downturn, your other investments may help balance out your portfolio. This isn’t guaranteed, of course, as some slowdowns affect all parts of the economy to some extent. However, relatively speaking, some industry groups are often less affected than others in a recession.

With stocks, you can also consider diversifying by company size, usually defined by small, mid and large market capitalization¹ or “cap”; industry sector; and geography. As Canadians, we tend to favour a “home bias” — a large portion of our investments are in our domestic stock markets, even though Canada makes up a small fraction of the world's financial markets. By limiting your investments to your own backyard, you can miss out on global growth potential.

Across bonds, consider diversifying by maturities and credit quality.

Beyond the three categories mentioned previously, other asset classes include real estate, commodities like precious metals and natural resources, infrastructure, private equity and private debt. These investments may react differently than equities or bonds to different economic conditions. Adding them to your portfolio could provide added diversification, reduced volatility and risk and, potentially, greater risk-adjusted returns.

Although every investment comes with risk, a diversified portfolio can help minimize the overall risk of loss to your portfolio and provide more opportunities to profit. As we mentioned, with just a few similar investments, it’s more likely they will all decline at the same time, as a downturn in the economy can affect them all the same way. If you diversify your positions, a profit decline at one company can be offset by profit growth at another, leaving the overall portfolio in better shape. Exposure to bonds and cash will help to further diversify and stabilize a portfolio.

For the disadvantages of diversification, if you have only one investment and it performs very well, it would earn a higher rate of return by itself as compared to a diversified portfolio. However, it’s almost impossible to know in advance which pick will be the winner.

In addition, there are some economic conditions where all asset classes decline. Investors can sometimes be frightened away by the seeming severity of a downturn, or the uncertainty generated by an event — for example, the 2001 attack on the World Trade Centre or a presidential assassination. In some historical cases, diversification didn’t help. In these situations, which are often limited in duration but intense nonetheless, many investors will sell indiscriminately and hold cash until the future becomes a little more clear.

How you diversify your portfolio will depend on several factors, including your risk tolerance, investment timeline, your research and investment strategy. Once you determine the best portfolio mix for your needs, consider rebalancing from time to time as assets change in value. Asset classes with strong performance will start to make up a greater and greater percentage of your portfolio as time goes on. Consider rebalancing at set intervals — perhaps every 6 or 12 months, for example — even when it means selling a portion of your winners. This helps ensure that your portfolio will continue to reflect your investment plan and stay diversified.

Next up is Lesson 4: Why invest in stocks?

¹ Market cap is calculated by multiplying the number of shares outstanding by the current trading price of a single share. This number tells investors how much a public company is worth in dollars.