Have you ever heard a financial professional use the word “diversification,” and wonder what they're talking about?
Investopedia defines diversification as, “A risk management technique that mixes a wide variety of uncorrelated investments within a portfolio with the goal of smoothing out unsystematic risk events, so that the positive results of some investments will outweigh the negative performance of others.”
We think we can make that a lot more simple.
Let's frame it in a few other ways so you can better understand this important concept.
As Canadians, we can all get pretty passionate about hockey. Let's take the beloved (or despised) Toronto Maple Leafs and pretend we’re the coach. We have a big game tonight against the Pittsburgh Penguins, and the game’s top sniper Sidney Crosby. When devising a game plan to shut him down we can think of two options:
When Crosby has the puck, you tell all 5 players on the ice, to skate after Sid “The Kid”. Great, right? Could be! But what if Crosby manages to somehow pass the puck to one of his other open teammates? More often than not you will lose.
Your other option is to make your players aware of their surroundings when Crosby has the puck, you may even “double team” him to slow him down but you still have your players cover the others because they have the ability to score on you as well.
Diversification works the same way. You could bet the farm on one or two stocks but what if by some “fluke” you picked the wrong two and you lose the game? In this case the game is your hard-earned money.
Don't take a risk on one stock just because you really like it. Something can always go wrong. That is why we prefer to hold Exchange Traded Funds (ETFs) that spread out our risk. We may increase our holdings in a certain ETF if we think it's our best idea, but we believe in maintaining a fully diversified portfolio.
At Wealthsimple, we invest in a diversified portfolio of stocks, bonds and other asset classes tailored to your risk tolerance. We believe they represent the best long-term sources of growth, income, and stability for investors.
Still a bit confused? Let us provide you with another example. What if you have a sweet tooth (like we do). As great as sugar is, we know that if we just ate delicious candies and chocolates every day we would surely run into some serious health problems. As a result, we know to eat a balanced diet full of grains, vegetables, and protein, if we want to remain healthy and enjoy candy far into the future.
You may work for a company that you believe in, or may have heard that a certain stock will make millions overnight through the grapevine, but it's not good financial sense to put all your proverbial eggs in one basket. You should always remember that everyone needs a well-balanced portfolio that consists of different asset classes for a “well-balanced diet.”
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