Diversification: Are you doing it right?

12 July 2022 by National Bank Direct Brokerage
A puzzle of diversified, colourful pieces near completion.

“Don't put all your eggs in one basket” - sounds familiar? This investment term is often used because it best defines good portfolio management. Several studies have shown that asset allocation accounts for more than 90% of a portfolio's volatility and return1. This means that it is much more important to determine which asset classes to choose than the securities themselves.

Diversification: Are you doing it right?

The traditional approach to diversification is to allocate investments between the 3 main asset classes: cash, bonds, equities and for certain investors there is a 4th which is alternative investments. Each category is assigned a certain percentage weighting depending on one’s investment goals, risk level and time horizon. As an example: for a growth portfolio, the equity weighting will be higher while the cash and bond weightings will be lower. On the other hand, a conservative portfolio would typically have a higher percentage of assets allocated to the fixed income category and less towards equities. 

Diversification and asset allocation is about understanding how different asset classes fit together and interact within a portfolio to reduce risk and improve returns. As self-directed investors you have access to a wide range of investment products that can help you diversify regardless of portfolio size.  

 

Which different asset classes can I include in my portfolio?

 

Cash:

In general, holding large amounts of liquidity (cash) in your portfolio should be avoided. That said, depending on your personal circumstances and the type of account held, holding a certain percentage of your portfolio in cash can be justified. As an example, suppose you have a RIFF or RESP account and know that an upcoming withdrawal is needed. Having a cash reserve (liquidity) is better than selling investments when markets have declined. 

Many investors will also keep cash on hand for unexpected opportunities in the market. Cash can protect your capital, but you will lose purchasing power over time because of inflation.

 

Bonds (fixed income):

Bonds represent a loan made by an investor to an issuer (company or a government) for a set period of time, in exchange for regular interest payments (coupons). Once the bond reaches maturity, the issuer returns the bonds maturity value.

Historically, investors have purchased fixed income because they would smooth out portfolio returns over time and could be counted on to provide a certain stability during volatile times. 

Once an investor has decided how much of the asset class to hold, the next step is making a selection. Fixed income offers a wide selection of bonds from governments & corporations which can be short term, long term while offering different credit qualities. An investor can purchase individual bonds for their account or indirectly via investment funds or ETFs.

The advantage of owning individual bonds is that you can select the issuer and the maturity dates. The disadvantages of selecting individual bonds, especially in the corporate category, is the risk of the issuer going bankrupt or simply the lack of diversification with only holding a few issuers.

Many investors have opted instead for investing in bonds through fixed income ETFs  which provide instant diversification via multiple issuers held with low management fees, all the while without sacrificing choice.

Lastly, investors can also purchase Guaranteed Investment Certificates (GICs) with terms varying from 1 to 10 years with interest paid annually or compounded annually. GICs are issued by financial institutions and are available to direct brokerage clients.

 

Equities (stocks):

Out of the 3 major asset classes, stocks have provided the highest after-tax, long-term returns for investors and they continue to offer the potential of earning significantly higher returns than the other asset classes. With this higher potential return also comes higher risk and volatility, by holdings multiple stocks, investors can diversify their portfolio while lowering the overall risk within this category. 

Direct brokerage clients who prefer to hold individual stocks have access to Canadian and U.S. listed securities. Via American Depository Receipts (ADRs)2, they can purchase shares of companies that are listed on international exchanges such as Japan, Australia, Germany and many others allowing them to diversify their equity holdings.

Another option is to purchase Exchange Trades Funds (ETFs) or Investment Funds which can hold anywhere from a few dozen to a few thousand securities which provide instant diversification.

 

How to find securities with Technical Insight?

Why is sector diversification important in a portfolio?

There are a few reasons why sector diversification is essential for investors:

- It reduces the risk in case of market downturn. Some people might believe that holding five stocks in the same sector diversifies their portfolio. In reality, it only reduces the risk of holding one stock since they are all in the same sector, the overall risk remains the same. On the other hand, if the investor held 5 stocks in different sectors, they would have less risk if the market underwent a correction. 

- It balances the portfolio. Different market sectors can react differently when events occur. Some sectors may be impacted upwards, some downwards and others will hold their own. 

 

What is geographic diversification?

Geographic diversification involves investing in stocks or bonds from different regions of the world. 

Did you know that Canada represents less than 3% of the total world equity market value3? By investing in the U.S, International and Emerging markets, you will access the other 97% and gain access to markets and countries that are affected in the same way by economic news and are growing at different rates.

 

How to diversify based on market capitalization?

Investors are also able to diversify by selecting their securities based on the market capitalization (or market cap) of the stocks. They can select large cap, mid cap or small cap stocks, each type offering different growth & risk profiles. Many investors will hold some of the largest stocks within each exchange but are less familiar with the up-and-coming stocks who could one day become the next blue chip or the next great growth story. 

 

How can Alternative Investments fit in a diversification strategy?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories (cash, bonds, equities). Examples can include private equity, hedge funds, managed futures & derivatives contracts, commodities, infrastructure, real estate and cryptocurrencies

What makes them appealing is that they often move counter to the stock and bond markets and can be used as a hedge against inflation. This makes them worth considering for portfolio diversification. Depending on the choice of alternative investment, they can be used as a substitute for a portion of one of the other three asset classes.

 

Finding the right balance

Whether you are just starting out with small weekly contributions, $ 1,000 dollars or have a large portfolio and many grey hairs worth of experience, diversifying your portfolio is always attainable. Diversification can help you reach your long-term investment goals by helping you improve returns while lowering risk. The trick is to find the right balance.

 

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Key takeaways: 

It is important to diversify investments in order to reduce risk of a portfolio.The traditional approach to diversification is to allocate your investments between different asset classes with a given percentage allocated to each category depending on your risk level and time horizon. Here are the different assets types:

  • Cash: In general, holding large amounts of liquidity in your portfolio should be avoided. Cash can protect your capital, but you will lose purchasing power over time because of inflation.

  • Bonds are basically a loan made by an investor to a company or a government (issuer) for a set period of time, in exchange for regular interest payments. The advantage of owning individual bonds is to be able to select the maturity dates. The disadvantages of selecting individual bonds are the risk of the issuer going bankrupt and the lack of diversification with only holding a few bonds.

  • Equities or stocks are the most volatile of the 3 asset classes, but investors can take steps to diversify within this category to lessen the volatility.

  • Alternative investments are financial assets that do not fall into one of the conventional investment categories (cash, bonds, equities) and can be private equity, hedge funds, managed futures & derivatives contracts, commodities, real estate, real assets and cryptocurrencies.

Sector, geographic, market capitalisation and asset class diversification are important to reach a long-term investment goal. 

 

  1. Setting the Record Straight on Asset Allocation, 2012 
  2. American Depositary Receipt (ADR) 
  3. Distribution of countries with largest stock markets worldwide as of January 2022, by share of total world equity market value 

 

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Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently, and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

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