Diversification: Basis for all strategy
 We
know that no single investment, regardless of how secure,
will allow you to avoid all risk. If you hold only cash, GICs
or bonds, you face the inflation and interest rate risks described
in the section, Whatever
you do with money you face risk.
The only way to avoid those two risks is by adding more risk
by investing in equities. Although stocks do carry higher
risk, only stocks have the growth potential you need to beat
inflation and have a secure financial future.
By holding cash, GICs, bonds and stocks in your portfolio,
you’re employing a strategy called diversification,
possibly the most important and powerful investment strategy
you can use. It lets you accomplish two seemingly opposite
goals at the same time: Reduce your risk and increase your
returns.
In the early 90’s two economists won a Nobel Prize
for developing the Modern Portfolio Theory. They discovered
when you add together two investments whose returns react
differently to the same event, it’s possible to reduce
risk and improve performance at the same time.
Different market sectors and different investments can react
differently to the same events. For example, an increase in
interest rates can cause some investments to go up and others
to go down.
A diversified portfolio improves performance and reduces
the risk by adding the high return from equities to the solid
base of cash and fixed income investments.
In one sample 10-year period, a diversified portfolio earned
95% of the average return of an equities-only portfolio with
less than 40% of the risk. The risk in the diversified portfolio
is reduced because during times when equities were down, the
fixed income securities continued to provide earnings.
Diversification can be achieved on many levels
Some of the leading wealth management firms practice investment
strategies that diversify portfolios on 3 levels: By assets,
by investment style and by management style.
Diversification of assets –
Assets can be diversified on many levels. Most important,
by asset class, holding a mix of stocks, bonds and cash. Possibly
then by geographic sector taking advantage of global opportunities
and the fact that if one economy is weak, another is strong.
And then by economic sector, to include a variety of industries,
because when one industry is slowing down, another is picking
up. Each of these diversifications will serve to increase
returns and reduce risk.
Diversification of styles -
Each asset class is then diversified into multiple investment
styles - such as growth, value, and income and by market capitalization
including a mix of small-cap, mid-cap and large-cap companies.
Diversification of managers -
Portfolio returns can be enhanced by using multiple managers
with complementary investment styles who react in their own
ways to varying market conditions.
It would be impossible for most individual investors to achieve
such levels of diversification on their own. The amount of
capital required would be immense. But you can enjoy the advantages
of this kind of multi-level diversified portfolio through
certain mutual funds and investment programs.
If you would like to know more about how multi-level diversified
investments can help your portfolio, click
here to find the RBC financial planning professional closest
to you.
Important information about our financial planning services can be found at the bottom of our
homepage.
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