What are the Benefits of Diversifying My Investments?
Diversification is one of the cornerstones of traditional investment advice. The most common saying we hear is “never put all your eggs in one basket” and the moral holds true. Markets go up and down through economic change, business cycles, and a wide variety of factors changing investment outcomes. Managing these peaks and valleys is the primary goal of an investment plan. The best possible defense against risks in any investment strategy is diverse and well-balanced financial planning.
The most basic form of diversified investment strategy is a mix of stocks and bonds. Generally, those two asset classes perform differently depending on the market conditions of the day. Stocks often perform well when the economy is growing, unemployment is low, and consumers are confident when they reach for their wallets. Low interest rates help to generate stock market gains because many investors use loans/debt to buy stocks, driving up prices. When the cost of borrowing money is cheaper, it’s easier to find capital to invest in the markets.
On the other hand, bonds typically perform well in times of trouble. Bondholders have better protection against downturns in the market — they get paid out first in bankruptcy or corporate restructuring. The last investors to get paid are the stockholders, but they benefit from the upside (dividend growth, increased stock value, etc). Bonds are “safer” than stocks for many reasons, but they all work together to keep your investment in better shape if the company, industry, or economy struggles. If the market is heading for trouble, you want to be in bonds over stocks.
While it’s tempting to just own stocks in good times and bonds in bad times, it’s not always easy to predict the market. By holding a mix of stock and bonds, you can hedge your bets and hope to earn income from your investments. The right mix of stocks and bonds (and exactly what to buy in these asset classes) is up to you and your advisor to decide.
The spectrum of investment choices out there is very broad, and it’s nearly impossible to have a “perfectly-diversified” portfolio. Luxury goods such as fine art and collectibles are technically part of a diverse investment strategy along with foreign currency, cash, real estate, and literally anything you can buy and hold. In practice, diversification is a guiding principle more than a concrete strategy.
Diversified portfolios should include more than just a mix of asset classes. It’s important to diversify across countries, industries, size, management style, and investment alternatives. If you hold all of your investments in Canadian dollars or US currency, you are open to currency risk. Only investing in large-cap stocks (i.e. the biggest companies), your investment income can be limited. If you invest in the smallest companies only, your portfolio is liable to be very volatile.
Your advisor needs to understand your unique situation to provide the best possible advice for you and your family. Diversification is one of the most proven investment strategies to generate good returns without too much risk. It’s your money, so make sure to take good care of it. Chasing high returns can be addictive, but it pays to be patient and let diversity protect your investment portfolio over the long haul.