Diversification sounds easy, but in today's up and down market it's not that simple. Here are few crucial diversification tips.
1. Invest outside of Canada
Investors around the world have a “home bias,” meaning they like to own domestic stocks. But in Canada's case, owning only homegrown equities or funds could harm a portfolio. Canada's market is concentrated in three industries: financial, resources and materials. If you hold a Canadian fund, there's a good chance you're too exposed to these three sectors. To get proper diversification you need to look elsewhere, like the U.S., for sectors such as health care, consumer staples and technology.
2. A few countries won't cut it
At one time, having exposure to a few different countries was an easy way to diversify a portfolio. But today, global markets are more correlated than ever. When one market falls, so does another. There is still something to be said about owning emerging market countries -- China and India are growing faster than Canada and the U.S. -- but it's not good enough to diversify based only on location anymore.
3. Invest in different sectors
Investors should consider diversifying across sectors as some do better than others during different economic times. For example, telecommunications companies often do well during downturns because people will stop spending on other goods before they cut their cable or phone service. The auto sector, on the other hand, may underperform since people will wait until they have more money to buy a car. Own both and the better-performing sector should make up for the losses of the weaker one.
4. Understand asset classes
There's more to diversification than just holding different types of equities. It's even more important to diversify by holding various asset classes such as stocks, bonds and, in some cases, gold. Bonds are usually safer than stocks so owning some will lessen a portfolio's risk. Some experts say to hold a bit of gold -- no more than five per cent of your total portfolio -- because generally, gold rises when stocks fall.
Recommended asset diversification varies based on your age, with more room for higher risk when you're younger. When you're young, say advisers, put between 60 and 70 per cent of your assets in stocks and 30 to 40 per cent in bonds. Allocate more capital to bonds as you age.
5. Use the right tools to diversify
It's hard to be well diversified when you own just a few stocks -- but it's not impossible. Just make sure they're in different sectors, so if one falls because of industry trouble they don't all drop.
It's much easier to get diversification, though, by investing in mutual funds and exchange-traded funds. Mutual funds typically hold a variety of stocks, so you get exposure to many different companies. Exchange-traded funds (ETFs) usually hold all the stocks in an index so you can get exposure to even more companies without having to fork over thousands of dollars to buy stock in each business. Still, it's not good enough to own one Canadian ETF or mutual fund. You need to own four or five ETFs that cover off all sectors and countries.
These days, it may seem like everything rises and falls together, but in reality markets drop or climb by different amounts. During a specific time period, for example, the S&P 500 might see flat returns while the S&P/TSX Composite Index might be down 11 per cent. That's why it's important to own different investments -- diversification removes risk and can prevent a portfolio from taking a major plunge.