In this week’s blog post, we are going to talk about diversification and the benefits of having a well-diversified investment portfolio.
Diversification is the process of investing in more than one type of investment in a way that helps reduce the exposure to any one particular asset or risk and is commonly referenced to in the idiom “Diversification is your only free lunch.” It means owning more than one type of investment and furthermore, not necessarily more than one of the same type.
An analogy might better clarify what I mean, in my neighborhood there are several fantastic pizza places, lets pick one, Senore’s Pizza. Lets say, hypothetically, that Senore’s only offered cheese pizza on its menu. That would mean Senore’s would likely only attract people that like cheese pizza. Wouldn’t it be better to offer a variety of pizzas to cater to a broader array of palates? This could be viewed as simple diversification.
Senore’s could also be in trouble if you don’t like pizza. To offset this risk, they offer other menu choices as a complement or alternative to pizza. The same basic principle can apply to investing.
As an example, if you have an investment portfolio concentrated in ten oil and ten gas stocks instead of one oil and one gas stock, then either way you are in trouble if the price of oil or gas goes down. Same concept as Senore’s pizza. This is what we call concentration risk. To offset the risk of being too concentrated to any one stock you should consider owning a variety of stocks across different sectors.
Now this principle should be applied geographically as well. Simply owning a basket of Canadian stocks means that all your risk is concentrated on the Canadian stock market. If the Canadian stock market dips then your portfolio would likely go down as well.
The free lunch principle applies when you own many stocks and bonds ffrom many sectors from many countries. The free lunch refers to the fact that you expect to receive a return premium by simply being invested in a diversified portfolio as not all stocks, bonds, sectors and countries move in the same direction at the same speed.
There is much debate about how much should be invested in Canada, how much in stocks versus bonds and cash, and how much should be invested in any one sector. This is something you should discuss with your advisor because every situation is unique and investment strategies will vary depending on stage in life, time horizon and risk tolerance.
By diversifying your choices, you won’t be limited to only having cheese pizzas to sell.
Happy investing!
The CM Group
To receive weekly educational content on investing, savings strategies, financial planning and more- subscribe and follow the CM Groups Free Lunch Podcast, available across all listening platforms.
#CMGFreeLunch