What Is Diversification And Why Is It Important?

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If you’ve heard the saying “Don’t put all your eggs in one basket”, then you have an idea what diversification means. While this may apply to different areas of our lives, it is even more important when it comes to investing.

This is because picking a winning stock is quite difficult – it is harder than you think, even for seasoned professionals. You’re better off putting your money to work in several investments.

And that is one of the reasons why diversification is important.

What is Diversification?

Diversification is an investment risk management strategy of holding different investments or securities in a portfolio. With a diversified portfolio, an investor minimizes the risk that one bad investment will have a material impact on the overall performance of the portfolio.

To diversify a portfolio, you need to look at the portfolio on two levels: at the asset class level and then within each class.

For example, let’s say you want to build a portfolio with 20% allocation to equities, fixed income, real estate, commodities, and cash equivalent. You’ll be diversified at the asset class level, called asset diversification.

But you need to go beyond that and diversify within each asset class.

Within each class, you should consider your exposure to different industries or sectors, geography, company size and so on.

Putting all your equities allocation in technology stocks may be tempting but could lead to a disaster.

Why Is Diversification important?

Diversifying your portfolio will not necessarily improve your investment returns.

That’s not the objective.

The reason why you need to diversify is to manage the risk in your portfolio. By spreading your funds across many investments, you have a higher chance of investing in winners.

How To Build A Diversified Portfolio

The first step to building a diversified portfolio is choosing an asset mix that aligns with your investment goals. Check this post for how asset allocation works and how to use it to improve your investing success.

The next step is to diversify within each asset class by picking investments across different:

  • Sectors (technology, financials, energy, utilities and so on)
  • Geography (U.S., Canada, international developed, emerging economies etc)
  • Company size (large, mid or small cap)
  • Investing style (Growth stocks like many tech companies or value stocks in telecoms)

For fixed income securities, you can diversify by bonds from different bond issuers (government or corporate), maturities (short or long term), credit quality and so on.

But how do you build a portfolio with securities from all these categories?

That is one of the limitations of diversification and why it can be difficult.

The Challenge With Diversification

For DIY investors, building a well diversified portfolio of individual securities is both costly and time-consuming.

Even if you can buy securities commission free, think about all the time you would need to spend on researching each investment and then monitoring them going forward.

So here are the cons and limitations of diversification:

  • Higher investment costs
  • It can be difficult to manage
  • Time-consuming

Luckily, there are ways to get around these limitations

How to build a diversified portfolio the smart way

One of the easiest and affordable ways to build a well-diversified portfolio quickly is by buying an Exchange Traded Fund (ETF). With a single purchase, you get access to a portfolio of stocks in your chosen sector, geography and so on.

You can buy an ETF for each of your desired asset class. But you’ll still have to rebalance periodically.

Alternatively, you can buy a single asset allocation ETF and never have to rebalance your diversified portfolio again.

Here are 5 all-in-one ETF offerings from iShares in Canada, with varying weights to equities.

Asset allocation ETFs from Blackrock (Ishares) in Canada

Investing through a robo-advisor like Questrade (QuestWealth Portfolios) or WealthSimple, or buying an index fund are two other ways to quickly build a diversified portfolio the smart way.

Check here to learn how asset allocation ETFs work and how to build a diversified portfolio.

The Link Between Rebalancing And Diversification

Rebalancing is another risk management tool in investing.

Building a diversified portfolio is not a one-time activity. Unless you’re investing using an asset allocation ETF or robo-advisor, you’ll have to monitor your portfolio regularly to be sure the risk is still within your tolerance.

At some point, your portfolio’s asset mix would diverge from your target mix. Rebalancing simply brings the asset allocation back to your original plan.

Related Post: Rebalancing 101: A Beginner’s Guide To Keeping Portfolio Risk In Check

Some FAQs

How can individual investors obtain the benefits of diversification?

The quickest, easiest and least expensive way is by investing through an all-in-one ETF.

Why is diversification important?

It reduces the risk of your portfolio. By spreading your money across many investments, you minimize the chance that a poor performance in one investment will have a major effect on your portfolio

What is asset diversification?

Asset diversification is the investment strategy of investing in different asset classes, such as equities, fixed income, commodities, cash and so on.

When should diversification be considered?

You should always consider diversification when investing. Why? Because it is hard, and almost impossible, to consistently pick winning stocks.

Final Thoughts

There are few guarantees in investing. And that is why you should focus on the things within your control.

Building a well diversified portfolio and rebalancing it regularly is one of those things.

Related Posts:

Further Reading: Investopedia on Diversification

Simon is a CPA by day and a Personal Finance Blogger by night. With over a decade experience in financial services, he's passionate about personal finance, investing and helping people take control of their financial life.

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