Are you putting all your eggs into one basket?
Have you ever wondered why street vendors often sell unrelated products. For example,sunglasses and umbrellas? That may seem weird, doesn’t it? After all, how often would a customer purchase both items at the same time? Street vendors understand that when it is sunny, it is easier to sell sunglasses but not umbrellas and vice versa. By selling both items or through DIVERSIFICATION of its product line, the vendor can reduce the risk of losing money on any given day.
Diversification is a strategy that reduces risk by allocating investments among multiple asset classes, industries and other categories. It intends to enhance performance by investing in various areas where each react differently to the same event. If you diversify your portfolio, your investment performance should be less volatile because losses from some investments are offset by gains in others.
When constructing your RRSP, TFSA, RESP, or RDSP portfolio, you should first understand your investment goals and risk tolerance. Is this for long-term retirement planning or will the investments be used in the next couple of years? How much downside risk can you tolerate? 10%? 20%? Secondly, you have to understand the risk among different investments, then you could decide what to include into your portfolio.
Mutual funds could be a great financial tools to achieve the diversification because each fund would own numerous stocks, bonds and so on. However, just because you are owning several funds do not mean you have a well-diversified portfolio. If all the funds you have are holding similar investments, then it would defeat the purpose. When designing a portfolio with funds, it is important to look at their correlation. Many Canadian funds are heavily concentrated in the financial, resources and energy sectors. In order to achieve superior diversification, you should consider diversifying across the board.Invest in different types of companies, and also different types of industries. The more uncorrelated your investments are, the better.
Diversification can assist investors to manage risk and reduce the volatility of a portfolio. Remember though, regardless of how diversified your portfolio is, risk can never be totally eliminated. You can reduce risk associated with an individual portfolio, but general market risks can impact most investment. The critical point is to find your right balance between risk and return. This will ensure you could reach your financial goals while still able to get a good night sleep.