Lesson 3: How to diversify your portfolio

A traditional investment portfolio will typically hold investments from three main asset classes: stocks, fixed income — also called bonds — and cash and cash equivalents. Some portfolios also include real estate and commodities such as precious metals, oil, etc.

The diversified portfolio mixes these choices because some of these investments will typically do well in periods of high economic growth, while others might thrive when the economy is growing slowly or during a downturn. Holding a variety of investments reduces portfolio risk but maintains the potential to grow.

In this article, we’ll discuss how to create a diversified portfolio by focusing on those three asset classes: stocks, fixed income and cash equivalents. You can buy and sell all these investments through an Investor’s Edge account.

As we mentioned, 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 — meaning, how much time until you need the invested money — and your risk tolerance will guide how much you’ll invest in each asset class. Longer time horizon portfolios can generally tolerate more risk, while shorter time horizon portfolios generally concentrate in less risky investments.

Stocks

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 highest long-term returns of the main asset classes, but they can be volatile, especially in a slowing economy. With stocks, you can consider additional diversification by company size, industry sector and geography. Canadians might consider diversifying outside of the country, as we tend to have a “home bias” — that is, a large portion of our investments are in our domestic stock markets. Since Canada makes up a small fraction of the world’s financial markets, you may want to also consider investments in some foreign stocks to benefit from global growth potential.

You can buy individual stocks, but equity exposure is also possible with stock mutual funds and stock-focused exchange traded funds (ETFs). Canadian Depositary Receipts (CDRs) provide an efficient way to buy fractional shares of foreign stocks in Canadian dollars.

Lesson 5 in this course discusses stocks in more detail.

Fixed income

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. Most fixed income investments provide some return with a guarantee of getting your money back if you hold the investment until it matures. The relatively rare exceptions are bond defaults.

Within the fixed income category, you can diversify with different issuers, maturities and credit qualities. Lesson 6 in this course discusses fixed income in more detail.

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.

Stocks tend to perform well compared to fixed income in a strong economy, when company profits typically rise. When the economy slows and companies begin to struggle, the stock market may decline, and bonds may start to look relatively more attractive. The idea is that a decline in one type of investment may be offset by a gain in another type.

Holding stocks, bonds and cash in an investment portfolio also creates some protection against volatility — the price swings that typically happen during a business economic cycle. Some investments will typically be less volatile when markets fluctuate dramatically, and changes in your portfolio value will be less dramatic when you hold a portion of stocks, bonds and cash. Many investors find this reassuring and it makes it psychologically easier to stay committed to an investment plan.

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.

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 provide higher overall returns. They may be worth considering for more sophisticated or experienced investors.

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. 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 similarly. By diversifying your positions, you can offset a profit decline at one company with profit growth at another, leaving the overall portfolio in better shape. Additionally, exposure to bonds and cash will help to further diversify and stabilize a portfolio.

Risk reduction

Diversification helps to spread risk across various investments, reducing the impact of a poor performance by any single investment.

Potential for higher returns

With a variety of investments, there are more opportunities for profit, as different asset classes may perform well at different times.

Potential lower returns

If you have only one investment and it performs very well, it would earn a higher rate of return by itself compared to a diversified portfolio. However, predicting the winning investment in advance is almost impossible.

Market-wide downturns

There are economic conditions where all asset classes decline simultaneously. For example, during significant market downturns or events like the 2001 attack on the World Trade Centre, diversification may not protect against losses.

Investors can be frightened away by a strong market downturn or the uncertainty generated by significant events. When financial markets react to these situations, many investors may sell indiscriminately and hold cash until the future becomes clearer. Diversification may not always provide protection in these infrequent but dramatic situations.

Once you create the best portfolio mix for your current situation, consider rebalancing from time to time.

You can rebalance by selling a portion of your strongest performers and buying more of the laggards. There’s a sound reason behind this idea. Investments with strong performance will naturally start to make up a greater and greater percentage of your portfolio as time goes on and their value rises. Rebalancing helps ensure that your portfolio still reflects your investment plan with appropriate diversification. You might consider evaluating your portfolio mix and possibly rebalancing at set dates — every 6 or 12 months, for example.

Finally, your situation or goals can change, and you may be able to handle more or less risk in the future. It makes sense to keep this in mind when you evaluate your portfolio mix to decide whether it still properly reflects your financial goals.

Next up is Lesson 4: Why invest in stocks?