I am sure we have all heard the expression “you should never put all your eggs in one basket”. Imagine you have a straw basket. In it, you decided to throw all the eggs you were going to eat for the week. While carrying it, you stumble over and drop the basket. In that fleeting moment, all the eggs you had preciously accumulated were destroyed.
Similarly, we have all heard the stories of those who took enormous risks and decided to roll all their savings into Nortel’s stock. They eventually discovered that their nest egg had been wiped out with Nortel’s shocking plunge.
If your eggs had been spread out across many baskets or your savings across many investments, that one plunge would be much less devastating!
Diversification is one of the golden rules of investing and is a key element that must be considered when building a proper investment portfolio. If our example was not enough to convince you, consider the following reasons you should consider diversifying your savings by investing in many different investments.
Down market, up market – your portfolio remains safe. When diversifying it is always wise to choose some assets that are uncorrelated with the others. Uncorrelated investments means that one investment goes up, the other investment doesn’t necessarily go up as well. By doing so, your portfolio will fluctuate less wildly and if there ever is a large drop in the Global economy like in 2007, you can count on some of your assets to protect you from a complete wipe out.
Different assets to suit varying investor profiles. Your age, your financial situation, your goals and your tolerance for risk all help contribute to your investor profile. Depending on these factors your portfolio will include different types of assets. Each type of asset will vary in proportions in order to help you achieve a certain return given a recommended risk profile. A conservative investor’s portfolio will include a larger component of fixed income securities (safe investments), which can include cash, GICs, government bonds and corporate bonds. On the other hand, a growth oriented investor will have a large exposure to equity securities (stock) which can include, Canadian, American and international stocks.
Many countries for growth opportunities. By being confined to one country you are exposing yourself to strictly one economy, including all of its political and socio-economic risks. What if a crisis arises and the economy tanks? Your investments are likely to follow. On the contrary, other economies may be booming and experiencing high growth rates. If you are not exposed to these markets through your investments you will be missing out on the potential upside. A proper mix of countries or regions in your portfolio will ensure you have ample exposure to new growth opportunities while balancing economic and political risk.
Why settle for one management team? In the previous Nortel example, no one would have expected the collapse that unfolded. In some cases, things are not always as they appear on the surface. Other times key executives decide to leave the company, or the company simply loses its competitive edge in the industry. When investing in one company you are depending on the performance of its management team. Investing in multiple companies will help diversify away from this risk, thus maximizing your odds of hitting a winning team and minimizing your chances of a major loss.
We can truly see that diversifying has its benefits; however like anything else it must be properly done. Overtime many personal and financial changes may occur in your life; these may affect your goals, your risk tolerance and ultimately your optimal investment distribution. This should cause you to review and update your overall distribution of investments in order to appropriately suit your needs.
Now, what are you waiting for? Diversify away!