Diversification is a key principle in investing, and it refers to the practice of spreading your investments among the different asset classes: stocks, bonds, real estate, and cash. These broad asset classes can be further subdivided – stocks, for example, should include Canadian, U.S. and international stocks, as well as large and small company stocks.
Why is diversification important? Each asset class performs differently as market and economic conditions change, and there is no way to predict which one will be the leader. The chart below shows how the returns and the ranking of each asset class have varied dramatically over the past 20 years. You can see how a diversified portfolio will have much more stable returns, by reducing its exposure to any one asset class.
The process of determining a portfolio’s asset mix is called strategic asset allocation. This recognizes that different asset classes have different risk-return profiles. Most portfolios will include some bonds or bond funds, which offer stability but relatively lower long-term returns, and some equities or equity funds, which are more volatile in the short term but have had higher long-term returns.
The goal of strategic asset allocation is to choose a portfolio mix that will maximize returns at a risk level that is appropriate for you (your “risk tolerance”).
Your risk tolerance reflects factors such as your investment objectives, the period of time over which you are investing, and so on.
If your portfolio is not properly diversified and its asset mix does not reflect your objectives, then it’s time to review your strategic asset allocation. However, if you have already gone through that process, it’s important to stick to your asset allocation, even when markets are volatile. Your asset allocation is tailored to your individual situation and should change only when your goals change. Furthermore, strategic asset allocation already takes into account the historical volatility of the different asset classes. Changing your asset allocation in response to short-term changes in the markets may actually hamper you in reaching your goals.
The Case for Diversification