What Is Diversification? Investment Risk Strategy

You've probably heard the saying "don't put all your eggs in one basket." In the investing world, that basket is your portfolio, and the eggs are your hard-earned dollars. This strategy is called diversification, and it's a core concept for managing risk while working towards long-term financial goals, especially during market swings.

In this article, we'll explain what diversification means, why it matters for your financial goals, and how you can put it into practice — whether you prefer to manage your own investments or let a professional handle it.

Key takeaways

• Diversification reduces risk: By spreading money across different investments, you avoid relying on the success of a single company or sector.

• It smooths out volatility: A diversified portfolio tends to have fewer extreme ups and downs than holding a handful of stocks.

• There are many ways to do it: You can diversify by asset class, geography, sector, and company size.

• It's easier than ever: All-in-one exchange-traded funds (ETFs) and managed portfolios can provide broad diversification with a single purchase.

What is diversification?

Diversification means spreading your money across different asset types, sectors, and regions so your results aren't tied to any single investment. It's a risk management strategy that helps protect your portfolio from major losses when one investment, sector, or market takes a hit.

Why is diversification important?

Diversification helps to protect your portfolio from large losses when individual investments underperform. By not relying on a single stock, sector, or asset class, you reduce the impact of market volatility on your overall wealth.

The thinking goes: if your portfolio is fairly well protected from risk, it will deliver higher returns over the long term — and you'll be more comfortable staying invested through rough patches.

Think of a specialty bulk candy store with rows of bins containing old favourites (like gummy worms) and strange novelties (hot dog-shaped marshmallows with an indistinguishable flavour). If you've got $10 to spend, how do you maximize your chances of getting something good?

• All classics: safe, but the flavour payoff might be modest.

• All novelties: what if they're too waxy or liquorice-flavoured? That's money down the drain (and gross candy in the trash).

• Mix of both: if the hot dog marshmallows are a bust, you've still got plenty of reliably good candies to snack on.

The positive performance of some candy offsets the negative performance of others — that's diversification in action.

Here's a less sugar-based example: in the 2008 financial crisis, investors with portfolios nearly entirely composed of housing-adjacent stocks (banks, mortgage companies) suffered huge losses when the housing market collapsed. Those with portfolios spread across different asset types may have experienced smaller losses and a smoother recovery, depending on their specific holdings and allocations.

How to diversify your investment portfolio

There are several different methods to build a diversified portfolio, based on what elements of an investment can be mixed and matched. Here's a closer look at the main factors.

Asset classes

Investing in different categories of assets is a common way investors diversify their portfolios. Here's how different asset classes typically function:

Sectors

Stability varies by sectors — some stay fairly consistent, while others move based on industry changes. By diversifying with stocks or ETFs of companies from a range of industries, the performance of your portfolio isn't completely dependent on one sector doing well.

Common sectors include:

• Technology

• Energy

• Consumer goods

• Utilities

• Telecommunications

• Healthcare

Geographic locations

Spreading investments across companies based in other countries means your portfolio's performance isn't entirely reliant on the health of one country's economy. Weather events, political unrest, and local economic conditions can all impact regional markets differently.

You can look to different markets like:

• Canada and the U.S.

• International developed markets (countries with similarly mature, dependable economies and stable regulatory systems, such as Japan, France, the U.K., Sweden, Singapore, etc.)

• Emerging markets (countries in the midst of transitioning to modern, industrial economies, with potential for high growth, such as Mexico, China, Brazil, Saudi Arabia, and Pakistan)

Risk, lifecycle stage, market size

You can diversify further by choosing assets with different risk levels (so long as you can handle varying risk levels). If you're investing in stocks or private equity, you can diversify by varying lifecycle stages and market capitalization.

• Risk profiles: an assessment of how risky any investment is based on factors like historical volatility and market conditions.

• Defensive stocks: stocks with similar expected returns that perform well at different times, reducing the risk of a bad outcome while keeping expected returns the same.

• Lifecycle stage: growth stocks are companies expected to grow faster than the overall market but can be volatile, while value stocks are established companies considered more stable.

• Market capitalization: higher cap stocks are typically stable, established companies, while lower cap stocks may have more risk but have historically had higher returns.

Self-directed vs. managed

When it comes to diversifying your portfolio, how you do it comes down to whether your portfolio is self-directed (DIY) or managed (by a professional or platform).

Self-directed

If you're a DIY investor, the level of diversification and how you diversify is up to you. Diversification can look different for every investor, based on how much money they're working with, what assets they're interested in, and how much risk they can tolerate. What's most important is to understand the risk profile of each individual investment before you decide how much money to invest and where.

Managed

A well-managed portfolio — whether it's managed by an individual, firm, or smart investing platform — is probably already diversified. Looking at an analysis of your portfolio can help you understand your current asset allocation. If you want to diversify further, you can request to rebalance it with your portfolio manager or change your risk portfolio.

Diversification checklist

Not sure if your portfolio is truly diversified? Use this checklist to spot potential gaps.

• Check for home bias: Do you own mostly Canadian stocks? Canada represents a small slice of the global market, so consider adding U.S. and international exposure.

• Review sector concentration: If you own five different stocks but they are all tech companies, you are not fully diversified. Ensure you have exposure to other sectors like financials, healthcare, or consumer goods.

• Look at asset correlation: Do your investments tend to move in the same direction at the same time? True diversification involves holding assets that don't move in lockstep (like stocks and bonds).

• Count your holdings: If you pick individual stocks, research suggests holding at least 20 to 30 companies across different industries to reduce company-specific risk. If that sounds like too much work, an all-in-one ETF might be a fitting alternative.

• Rebalance regularly: Over time, winners can grow and losers can shrink, which can shift your allocation away from your target. Rebalancing brings you back to your original diversified plan.

Pros and cons of diversification

Investing always comes with risk, even if your portfolio is diversified. Here are some reasons why diversification is a popular investing strategy — along with a few potential drawbacks to consider.

Pros of diversification

• Managing risk: a diversified portfolio can be helpful in minimizing your risk. It's less likely that losses in any one company or sector will drive the performance of your entire portfolio at the same time—though broad market declines can still affect many holdings.

• Preserving capital: while diversification usually won't lead to extreme short-term growth, it's a popular method of preserving the capital you already have while benefiting from steady, long-term growth.

• Access to different assets: diversification allows you to incorporate many types of investments at the same time, while leaning on other asset classes and industries to balance things out.

• Possibility of higher long-term returns: a diversified portfolio can help increase the odds that you'll benefit when certain companies or industries start generating high returns. And if that doesn't happen, a well-diversified portfolio will usually experience steady growth that mirrors the market.

Cons of diversification

• Limited short-term gains: because diversification means not betting a large amount on a specific company or sector, you could miss out on sharp short-term moves if your bet turned out to be fortuitous. But remember: the risk of incurring meaningful losses also increases when you concentrate your investments.

• Can be difficult to manage: if you're taking a self-managed approach to investing, you'll need to spend time researching, tracking, and rebalancing your portfolio to keep it diversified.

• Potential higher fees: more assets can sometimes mean more fees. You could end up paying commission and transaction fees (though not everywhere!) to hold a large range of assets, especially if you trade often.

• Increased risk without a strategy: if you're investing in anything and everything for the sake of diversifying, you could actually increase your risk. That's why evaluating the risk profile of every investment type is essential.

Diversification isn't a guarantee against losses. But a well-diversified portfolio often reduces exposure to investment-specific risk and can lead to more stable results over time, though outcomes can vary — even if those results don't include sudden and extreme upswings.

As with every investment strategy, remember: it works well when it suits your goals, investment style, and most importantly, your risk tolerance.