Seasoned experts and novice hobby traders have all heard about diversification. It almost seems like a buzz word on television, but why is it an investment strategy that is so universally known?
Boiling it down to the basics, diversification is holding investments that react differently to the same economic event or market.
“In other words, a well-diversified portfolio offers balanced growth and mitigated risk by spreading across multiple asset types and classes,” according to Fidelity Investments.
The old adage of “not keeping all your eggs in one basket” rings true in the investment world, too.
As author Justin Goodbread points out, the origins of the saying actually come from the “practical agrarian application”, and he learned it through collecting eggs with his father. Goodbread once made the mistake of filling the basket to the brim with eggs and running home, only to trip on a hose. The eggs went flying and the lesson was learned.
“Diversification protects your portfolio from disaster when you trip on a hose with your egg basket,” he explained.
By diversifying, investors can earn the benefit of reduced risk without diminishing returns.
Asset classes and how they can be diversified
Cash/cash equivalents
While cash and cash equivalents are wonderful assets to have, they are also subject to inflation, so it might be best to not rely heavily on them. Cash and cash equivalents are great assets to have. However, they are subject to inflation, so you may not want to rely too heavily on them. Cash and cash equivalents can be diversified, however, by purchasing them in three forms: crypto currency, foreign currency and Canadian currency.
Fixed income and bonds
Bonds typically allow for you to loan money to the bond issuer, which is usually a corporation or the Canadian government. They then pay it back with interest when the bond reaches maturity. Much like other asset classes, bonds and fixed income come with a variety of options, and each one responds uniquely to different market fluctuations.
Canadian equities
These are common stocks found on the Nasdaq Canada or Toronto Stock Exchange, with each one representing a Canadian business. Ideally, your portfolio will have a variety of equities from within the market. These can be further categorised as large-, mid-, and small-cap companies and even further as growth or value stocks. These may have different risk/return ratios and differing rates of return, depending on the type.
Commodities
These are broadly defined as anything someone is willing to pay a price for.
“Commodities are any goods that are readily tradable or sellable for the exchange of currency or goods, such as gold, oil or even soybeans and livestock,” according to the article. “There really aren’t any limits to the ways that this asset class can be diversified.”
Real estate
This is one of the most popular asset classes available because it qualifies as a hard asset, or something tangible as in physical property, contrary to stocks and bonds. Real estate is also a naturally diverse asset type, particularly considering that investments can range from residential and commercial properties, and even mining, farmland and timber.
Global markets
Global markets involve equities that are exchanged or traded on the international market, but also have the same options as in small-,mid-,large-cap/value and growth and also have the same kind of risk/return ratios. Further, the global market asset class can add a remarkable amount of diversification to a portfolio.
Global fixed income
“Just as global markets are to U.S. equities, global fixed income is to bonds and fixed income. It’s the same basic idea but spread out to include the international market,” according to the article.
Like the bonds and fixed income asset class, global fixed income Similar to the bonds and fixed income asset class, global fixed income provides greater diversification through government and general obligation bonds.
There are a host of other asset classes available to investors. These are simply a few of the most popular.
“Regardless of when or how you choose to invest, adding diversity to your portfolio offers the benefit of mitigated risk without diminishing returns,” according to the article. “As always, this is not advice, and you should conduct your own due diligence before making any investment decisions.”