From saving for retirement to funding your child’s post-secondary education, investing can be an excellent way for Canadians to grow their wealth over time. Now, all investments carry financial risk, and with so many options available to you, deciding how to allocate your funds can feel daunting. Whether you are a novice or a seasoned investor, you can reduce your financial risk and protect your overall financial future by not putting “all your eggs in one basket”– that’s where diversifying your investment portfolio comes in.
What is diversification?
Diversification involves spreading your investment dollars across a range of assets to reduce the impact of the low performance of any singular security in an investment portfolio. By spreading your money across various investments – including equities, alternative assets, fixed-income funds, and mutual funds – you increase your chances of having money coming in during bull and bear financial markets.
How does diversification reduce your risk?
Are you a technology fanatic eager to invest all your money into your favourite tech company like Apple or Microsoft? Well, think again. By holding all your money in just one type of investment, you could be putting your financial security at risk. If that investment doesn’t perform, you could be saying goodbye to some or all, of your hard-earned cash. By diversifying your money across a range of different investments, you can balance out your financial risk because all your investments are unlikely to underperform at the same time. Selecting a range of different investments into your portfolio – such as mutual funds, ETFs, and equities – will allow you to be better equipped to bounce back from financial losses.
Alan Dheere, a Financial Planner at Vancity Credit Union, shares his views on the role of diversification and how it serves as a compelling investing strategy for Canadians “My advice to Canadians interested in incorporating diversification into their portfolio is to start out by investing in broad market funds such as index funds, or ETFs or mutual funds that have a broad array of holdings. This is the best way to give yourself exposure to the markets and manage your risk.”
Here are a few investing strategies to help you build a diversified investment portfolio:
1. Diversify by Asset Class
An asset class refers to a grouping of investments based on shared behaviours and similar risk and return characteristics. Investing across a series of asset classes rather than solely in one market can reduce your risk of losing all your money. The three common investment asset classes include cash, fixed-income securities, and equities. By adding both equities and cash equivalent investments to your investment roster, you’ll help even out your overall portfolio returns because these asset classes will differ in risk and financial return. For instance, if the equities in your portfolio are taking a financial hit this quarter, you may see your cash equivalent investments hold or rise in value at that time, which will balance your portfolio returns and reduce your risk of undergoing a sizable financial loss.
2. Sector-based Diversification
Financial services. Healthcare. Information technology. These are three of the many sectors you can invest your money in. While investing allows you to put your money towards the companies that align with your values, make sure not to put all your money in one place! Consider spreading your finances across a range of stocks in different sectors to reduce your financial risk during periods of economic instability. With the help of a sector-based diversification strategy, you can allocate your money toward investments across various industries, reducing your risk of exposure to a single sector’s poor performance. So, if your portfolio currently consists only of shares of your favourite cosmetics brand, consider incorporating institutions in the healthcare space and a telecom company into your portfolio. This way, if one sector takes a hit, you can still flourish financially from the financial growth seen in other areas you’ve invested in. Simply put, don’t let one sector take down your financial future.
3. Diversification by Time-Horizon
Are you looking to fund your retirement? Or are you looking to finance your post-secondary education? As we all know, investing is a long-term game, and having a diversified portfolio that reflects all the different stages of your life can help you manage your financial risk and improve the overall performance of your portfolio. By spreading your money across short-term, medium-term, and long-term investments, you’ll reduce the impact of market volatility by balancing out the effect of short-term market fluctuations on your investment portfolio and preserving your capital to achieve your short- and long-term financial goals.
4. Diversify by Geography
From political instability and economic crashes to unforeseen pandemics, countries can face many ups and downs affecting their citizens and their financial markets. Adopting a geographic diversification approach involves spreading your money across investments in various regions and nations. So, suppose you have money invested in organizations within the U.S., and there is currently political unrest in the country – you’ll likely see the negative impact of these events on your investment returns. To help ease the squeeze on your pocketbooks from these underperforming investments, you might consider allocating a part of your portfolio to investments in other financial markets. By adopting a geographic diversification strategy into your investment portfolio, you can reduce the economic impact of global economic and political instability on your investments and take advantage of financial growth potential in emerging nations. Now that’s a win-win!
5. Risk Diversification
How would you feel if your $5,000 investment suddenly was only worth $2,500? Did your heart sink for a moment? When it comes to investing, there is no question that it can be a risky business, and how much risk you take depends on your risk tolerance and the investments you select in your portfolio. Risk tolerance refers to your ability to tolerate fluctuations in your financial return. Different investments carry different levels of risk – typically, the higher the risk, the higher the return, but also the greater risk for a financial loss. Understanding how much investment risk you are comfortable with can help determine your investment style and ability to withstand financial losses.
If you are a retiree or on a fixed income and thinking of adopting a risk diversification strategy, you might only want to invest your money in the short term as you’ll need access to the funds sooner. With this shorter time horizon, you may want to play it safe and allocate most of your money toward fixed-income investments. The returns on your investments may not be substantial, but you’ll guarantee you don’t lose your initial capital. Alternatively, suppose you are 25 and at the start of your career. You may have a higher risk tolerance and can incorporate higher-risk investments into your portfolio as you have more time to recoup any losses. Not sure what type of investor you are? Consult with a financial advisor at your local credit union to get a holistic picture of your financial standing and risk tolerance to help you build the risk-diverse investment portfolio that is right for you.
Diversify your investments with the help of a Credit Union
With so many factors to consider, investing can be an overwhelming endeavour, but diversifying your investments will reduce your financial risk and preserve your overall financial well-being. Credit unions are a great banking option to help you identify the right mix of investments to meet your specific financial needs and comfort level. Not yet a credit union member? Find your nearest credit union, here.