A version of this article originally appeared in Inspired Investor, the RBC Direct Investing magazine.
Diversification means holding various types of investments in your portfolio. When choosing how to diversify, start with your investor profile. The appropriate mix of the basic asset classes – cash, fixed income and equities (your asset mix) will depend on your investment objective and other factors such as time horizon and comfort with volatility. Within each asset class, each investment can act as a building block with the objective of creating a portfolio with a solid foundation.
- Cash and cash equivalent investments can provide you with a stable base for your portfolio and easy access to cash to tap into on short notice. One potential drawback – returns may not keep up with inflation.
- Fixed Income investments generate cash flow and can provide some stability to your portfolio. Can be sensitive to movements in interest rates. Explore and learn more in Fixed Income: The Basics.
- Equity investments provide the greatest potential for long-term growth along with a higher degree of risk. Explore and learn more in Stocks: Understanding the Risk-Return Relationship.
A well-diversified portfolio
Financial markets do not typically move in concert with one another. In addition, no one can reliably predict how a particular asset class will perform in any given year. One asset class may be leading the market while others lag and it may be completely different the next year.
As markets will always fluctuate, investing in a number of investments in a diversified mix of equities, fixed income and cash may help protect your portfolio from a decline in value. The concept behind diversification is that assets that are increasing in value can work toward compensating for others that may be decreasing. This can help to reduce the overall risk in your portfolio and smooth out returns over time.
More ways to diversify
Various methods are used by investors to diversify their portfolios including by:
- Geography: diversifying assets globally can help to reduce the risk of being exposed to any single country and can give you access to opportunities not available in Canada.
- Economic sector: By holding investments across a broad range of industries, you can protect your portfolio from downturns in any one sector.
- Number and concentration of holdings: A larger, more diverse number of investments with less concentration in any one holding, can reduce a portfolio’s exposure to company-specific risks.
- Management style: Diversifying by management style can help smooth portfolio returns as different management styles react uniquely to market conditions.
- Market capitalization: Diversifying by size – small-cap, mid-cap, or large-cap companies – can provide you with a range of investments with exposure to broad market opportunities.
- Alternative investments: Many investments fall under this category because they do not typically move in sync with traditional asset classes. Examples include real estate investment trusts (REITs), structured products, precious metals and more.
Some trading platforms have tools that can help you review your asset mix. For example, RBC Direct Investing has the Portfolio Analyzer tool which allows you to easily view your portfolio’s mix of investments and level of diversification to monitor risk. You can then drill down to sector and regional exposures, or check your holdings to see where you might be concentrated.
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