Why diversification matters
Investing can be unpredictable. Will interest rates remain the same, go up or fall – and when? Exactly where are we in the market cycle, and how long until we enter the next phase? Will a geopolitical event, health crisis or other incident shock the markets? Which investments offer the most opportunity over the next year?
Everyone can try to make predictions, but no one can always know the answers. That’s one of the key factors behind the strategy of creating a fully diversified portfolio. Since we can’t predict the market leaders or underperformers year to year, it’s best to cover all bases.
Benefits of diversification
A well-diversified portfolio can benefit investors in three key ways
Minimize risk. By spreading your investment dollars across a variety of investments, you ensure that you won’t be over-invested in any particular underperforming market.
Enhance performance. Every January, investment analysts predict which markets will be among the year’s leaders, and invariably every December we’re reminded to expect the unexpected. However, if your investments are fully diversified, you will likely have some exposure to the year’s market leaders, which can potentially enhance portfolio returns.
Reduce volatility. If a portfolio only includes a handful of investments that respond alike to the same economic conditions, portfolio returns could rise and fall sharply at the whim of the markets. A fully diversified portfolio is constructed with investments that react differently to economic conditions, which smooths out returns and reduces portfolio volatility over time.
A look at market indexes
Talking about portfolio diversification in theory is instructive, but the benefits are much clearer and more impactful when you view market unpredictability in reality. Take a look at the table below to note the following observations.
The notion that an investment can go from laggard to leader in just one year is demonstrated by Global Bonds. In 2017, they sit at the very bottom rank, then in 2018 Global Bonds rise to market leader.
To see how any investment can be unpredictable year to year, follow Canadian Equities from left to right to track a zig-zag path that hops up, down and in between.
By diversifying, you have a greater chance of gaining exposure to the best-performing markets. In just the six years represented on this table, four different indexes held the position of market leader.
Ways to diversify
The broadest way to diversify an investment portfolio is through investing in different asset classes, the major ones being equities, fixed income and cash equivalents. You can also be diversified within each asset class. For example, within equities, you can be invested in small-cap, mid-cap and large-cap companies – “cap” or capitalization referring to a company’s size.
Investment style offers another way to diversify, as value and growth investments often take turns outperforming each other. Investing in a variety of geographic regions also provides all the benefits of diversification – and opens up specific investment opportunities less available in Canada.
If you would like to talk about the various ways your investments are diversified, please get in touch.
Market leaders change year to year
Financial market indexes ranked in order of performance
Canadian Equities: S&P/TSX Composite Index | U.S. Equities: S&P 500 Index | International Equities: MSCI EAFE Index | Emerging Markets Equities: MSCI Emerging Markets Index | Canadian Bonds: FTSE Canada Universe Bond Index | U.S. Bonds: Bloomberg U.S. Aggregate Bond Index | Global Bonds: Bloomberg Global Aggregate Bond Index All returns are in Canadian dollars. This table is provided for illustrative purposes only. Note that it is not possible to invest directly in an index. Source: Morningstar Research Inc., December 31, 2021.