What Is Diversification and How It Can Help Reduce Your Investment Risk
Diversification is an investment approach where you spread your money across various types of assets to reduce overall risk. The aim is to balance both the overall risk and your potential returns.
This strategy helps shield your savings from the ups and downs of the market. This happens because different types of investments, such as stocks and bonds, often move in different directions. If they move in the same direction, they often do so at different speeds or to different degrees, which helps smooth out the impact on your portfolio.
Does diversification help to reduce risk?
Relying on a single investment can be risky. If that one investment loses value, you could end up losing a sizable portion of your money.
By spreading your money across a mix of different assets—such as stocks, bonds, real estate, and even across industries or countries—you reduce the impact that any one investment can have on your entire portfolio. If one investment performs poorly, others may perform well, helping to offset losses.
How can you diversify your investment portfolio?
Here is how you can diversify your portfolio:
- Invest in a variety of asset types (for example: stocks and bonds)
- Varying the level of risk within investment types (for example: include low, medium, and high-risk investments)
- Diversify across global markets, including Canada, the U.S., Europe, Asia, and emerging economies. Keep in mind the potential impact of currency fluctuations, known as foreign exchange (FX) risk.
- Include companies of different sizes in your equity portfolio, such as large-cap, mid-cap, and small-cap firms.
- Use investment funds with different management styles, such as active, passive, growth, value, etc.
- Spread your investments across various sectors, like finance, technology, and healthcare, to reduce exposure to any single industry.
How does investment risk vary by age?
Your age tends to dictate how much risk you are willing to take on in your investments.
- Early Career: with many years before retirement, time is on your side. You can afford to take on more risk in your portfolio to pursue higher long-term returns.
- Mid-career: retirement is still years away; it is a suitable time to aim for balanced growth. You will want a moderate increase in the long-term investment portion of your portfolio.
- Close to retirement: as retirement approaches, it is important to align your investments with your income needs. This is the time to reduce your portfolio’s investment risk as you approach the years where you will need to be withdrawing from your portfolio.
While diversification does not eliminate risk entirely, it helps manage and limit it—making your investments more stable over time. Speak with an advisor about what level of risk is right for you, and how to diversify your portfolio.