What is Diversification and Why Does It Matter In Investing?

It’s classic investment advice: diversify your portfolio!

But if you’re new to the world of investing, that probably means less than nothing to you. Diversify with what? And how?

The good news is, I guarantee you’re already familiar with the concept of diversification. Do you wear the same thing to a wedding as you do to go to the gym? It’s unlikely, because you have a diversified wardrobe: different clothes to suit different occasions.

That’s why you want a diversified investment portfolio, too. Different investments will do better or worse in a given time frame, and if you have a little bit of all of them, your overall portfolio is better prepared to handle any scenario—just like your closet is when you have both your cherished lululemon Aligns and a party dress in there.

So let’s dig into what that looks like for investments, and how to make sense of it as a beginner.

What is diversification?

When it comes to investing, diversification is a risk management strategy that involves investing in multiple different types of investments in order to lower the risk of holding any single investment.

Basically, investing in something that might go up or down is less risky overall when you already own a wide range of other investments, especially when the performance of all of your investments isn’t likely to change all at once.

You can diversify your portfolio in a few different ways.

  • You can diversify by location: investing in your home country and international countries, too.
  • You can diversify by asset class: investing in stocks, and bonds, and GICs, and ETFs, instead of just one of them.
  • You can diversify by industry: investing in tech, and real estate, and healthcare, and construction, instead of just one of them.

And don’t worry: you don’t need to find and buy each of those investments on your own. There are beginner-friendly ways to build a diversified portfolio that require almost 0 work on your part—but first, let’s look at an example of why you really, truly will sleep better with a diversified portfolio.

Why should you diversify your investments?

This chart is a perfect example of why you need to diversify your portfolio—and as a classic Finance Chart, it’s nearly unintelligible if you don’t understand money stuff. (Seriously, it’s hard to look at.)

Source

The point of this chart is to show you that from year to year, one specific type of investment can do really well, and then really poorly. Take this example I pulled out from that chart, looking at Bloomberg Barclays Aggregate US Bond Index.

Diversification: how one fund did over time

Bonds are typically seen as a lower-risk thing to keep in your portfolio. In some years (specifically, 2002, 2008, and 2011) this investment was leading the pack with the absolute highest returns of all the categories. In other years, it had the absolute lowest returns of any investments on the chart.

On the flip side, you can look at another investment on the chart, MSCI Emerging Markets. Emerging markets are typically seen as riskier places to invest your money, and while this investment led the pack on returns for a number of years, it literally went from lowest returns to highest returns, and then back to lowest returns in a three-year time span (2007 to 2009).

Diversification: how one fund did over time

But look at what happens if you overlay those two on top of each other. If you held some of the bond index, and some of the emerging market index, you actually owned some of the high-performing investments in almost every year. That’s true even when the other part of your portfolio wasn’t doing so hot—except in 2013, when they both did poorly, and other investments took the lead.

Diversification: a look at how two funds performed over time

That’s diversification in a nutshell. If you own multiple investments in multiple industries, asset classes, and countries, a bad year in one area is more likely to be cushioned by a good year in another.

You might not earn 75% returns in a single year, but you’re also less likely to lose 75% in a single year.

So how do you actually diversify?

Setting up a diversified portfolio is about a zillion times easier than it used to be, especially if you’re just getting started. All you really need to worry about as a beginner is not putting all your money into a single type of investment—so no, you shouldn’t throw your first few thousand bucks into the Uber IPO, cryptocurrency, or a cannabis stock.

Instead, there are a few well-diversified options that make things easy, or at least easy-adjacent, as a beginner.

  • Roboadvisors. The big selling point of roboadvisors is that all you have to do is tell them a bit about yourself, your goals, and your risk tolerance, and they build you a low-cost, diversified portfolio automatically—you just set up automatic contributions and the rest is handled. It’s truly the easiest and most beginner-friendly way to build a diversified portfolio, and if you’re just getting started, it’s what I recommend. Get your first $10,000 managed for free when you sign up for Wealthsimple using this link.
  • Single-solution ETFs. If you’re willing to do a tiny bit more work, and understand a bit more about the process, there are low-cost, single ETFs that are designed to deliver a full, diversified portfolio for even less than a roboadvisor charges (which isn’t much in the first place!) However, you’re on your own for choosing the right single-solution ETF for your needs, and you need to manually buy it every time you want to invest more money. If you want to take this route, your best bet is an online brokerage like Questrade.
  • ETF portfolios. If you’re willing to go a step further to understand ETFs and use them to build your own portfolio, you can get more control and a lower price than even the single-solution ETFs. However, you’ll then need to learn how to rebalance your portfolio to make sure your ideal asset allocation is maintained over time. If that sounds like absolute mumbo-jumbo, there’s an easy answer: this isn’t the right strategy for you yet!

Diversification gives you a solid foundation

A diversified portfolio is the perfect way to start investing for a few reasons. It helps you get into the market while (mostly) protecting you from losing absolutely all of your money, since it’s unlikely that the entire economy of multiple countries is going to go down to zero. It also gives you a solid foundation to build from when you’re ready to start exploring more advanced options, like buying more specific investments in companies and industries you believe in.

But if you take only one thing away from this, let it be that over time, you can never predict which type of investment is going to do best next year: so if you want to make sure you capture those gains, your best bet is to own most of them in the first place. That’s diversification.