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What is diversification?
Learn how a diversified portfolio can help manage risk, reduce volatility and capitalize on returns.
CIBC Investor’s Edge
Jul. 27, 2021
3-minute read
Even if you're new to investing, you've likely heard the old adage, “Don't put all your eggs in one basket." In other words, if you focus on just one type of investment looking for a big payoff and the bottom falls out, you risk losing all your eggs.
Building a resilient portfolio
One of the best ways to manage this risk while capitalizing on returns is to diversify your investment portfolio. Diversification simply means holding a variety of investments that will react differently to market or economic events.
For example, in a strong economic market (or "bull market"), stocks tend to perform strongly versus bonds. But when the market slows and interest rates rise, investors often take bonds into consideration. Holding both stocks and bonds in an investment portfolio helps make it more resilient against market ups and downs.
Advantages and disadvantages of diversification
Every investment comes with risk. A diversified portfolio may help minimize the risk of loss to your overall portfolio and provide more opportunities to profit. When you have just a few similar investments, you’re more likely to experience loss to all of them at the same time. If you diversify your positions, when a single investment’s growth or profit gets affected, the rest of your portfolio may remain intact. If you invest in securities that tend to behave differently in the same market conditions, some may drop in value, while others may increase, potentially more than offsetting your loss.
On the downside, diversification can reduce your potential profit. If you had only one investment and it performed very well compared to others in your portfolio, it would earn a higher rate of return than the diversified portfolio.
How to diversify your portfolio
Investment markets experience ups and downs, and there are no guarantees as to which asset class will perform best at any given time. The best way to benefit from market returns is to invest in a broad range of investments.
Depending on your time horizon and risk tolerance, your portfolio could be made up of 3 main asset classes in different percentages.
Stocks allow you to own a piece of a company and benefit from its growth and profitability. Equities have historically provided the strongest long-term returns, but they can be volatile, especially in a slowing economy.1 Learn more about stocks.
Fixed income, such as bonds and GICs, are essentially units of debt issued by governments, corporations or other institutions. Fixed income typically offers more moderate returns and less volatility compared to equities. Learn more about fixed income.
Cash and cash equivalents
Cash and cash equivalents are most liquid assets that offer the least amount of risk in exchange for lower returns.
Diversification is also important within each asset class. For example, consider diversifying across stocks by market capitalization (small, mid and large caps), sectors and geography, and across bonds by varying maturities, credit qualities and duration.
Other types of asset classes
Beyond these 3 categories, other types of asset classes can include real estate, commodities (like precious metals or natural resources), infrastructure, private equity and private debt. These alternative investments may react differently than typical equities or bonds and adding them to your portfolio may offer additional diversification, reduced volatility and risk and potentially greater risk-adjusted returns.
To avoid being overexposed to one particular geographic region or market, aim for a well-rounded mix of global exposure. As Canadians, we tend towards a "home bias." In other words, a large portion of our investments are in domestic markets. Yet Canada makes up just a small fraction of the world's capital markets2, so by limiting investments to your own backyard (depending on your risk tolerance), you may be missing out on global growth potential.
How you diversify your portfolio will vary depending on a number of factors, including your risk tolerance, your investment timeline, your own research and your overall investment strategy. Even once you’ve determined the best portfolio mix for your needs, you should consider rebalancing over time as assets change in value. Consider rebalancing at set intervals – at least every 6 or 12 months , for example – to ensure your portfolio continues to reflect your investment needs.
