Diversification is a risk management technique that combines a variety of investments in order to reduce the impact that any one security has on a portfolio's performance. A diversified mix of investments can lower an investor's overall risk without necessarily reducing their potential return.

It's important to recognize that all mutual funds are subject to different risks and potential rewards. Generally speaking, the higher a fund's risk profile, the higher the potential reward. While the overall risk profile of a portfolio can be lowered by selecting a variety of different investments, one can never fully diversify away all risk.

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Asset Class

In order to reduce the overall volatility of a portfolio, investors should avoid putting all their eggs in one basket. This entails investing in a number of different types of funds in your portfolio, including equity, fixed income, and money market funds. If the funds selected by an investor are sufficiently different, the risk to the entire portfolio will generally be lower than the risk associated with any single fund.

Major Fund Categories

Money Market Funds: these funds invest in very short-term debt instruments, most notably Government of Canada Treasury Bills (T-bills) and commercial paper issued by financial institutions. The average maturity of a money market fund is less than 90 days. Money market funds are considered very safe investments, with only a remote chance that unitholders could lose their principal.

Money market funds are an ideal parking spot for short-term savings, and typically pay higher yields than traditional deposit accounts.

Bond Funds: typically pay unitholders regular income, usually on a monthly or quarterly basis; however, the acutal amount of the payment will flucutate, and along with unitholders' orginal investment, is not guaranteed. (Unlike individual bonds, bond funds do not offer a set term to maturity or interest rate.) Generally speaking, bond funds are riskier than money market funds, but less aggressive than equity funds.

Bond funds are one of the simplest and most effective ways of diversifying your investments. Since bond markets often move in the opposite direction to equity markets, gains from bond funds can help offset losses from equity funds, lowering overall portfolio volatility.

Equity Funds: these funds invest in a basket of stocks. Stocks are the riskiest of the three major asset classes, but have outperformed both bond and cash over the long run. Equity funds can experience fairly significant price swings over short time periods, and are therefore typically recommended for long-term investors. Not all equity funds are alike - some are more volatile than others. For example, funds that focus on smaller companies or one sector or industry are generally more aggressive than funds that focus on large well-established companies, dividend-paying stocks, or are diversified across a wide range of sectors.

Equity funds are best suited to investors who are seeking long-term capital appreciation, but can tolerate moderate to more significant declines in the value of their investments over a short time period.

Geographic To top

Geographic diversification means including different countries and regions in a portfolio. Because Canada represents less than three percent of global equity markets, international funds are an effective way of capitalizing on global investment opportunities. Despite increasing economic globalization and stronger correlation among international markets, different countries and regions will often move on country specific dynamics, such as economic and political forces.

Sector To top

You can diversify a portfolio along more than asset class and geographic lines. Sector diversification means including investments from different sector and industries in your portfolio. Not all sectors react to economic cycles in the same manner; some industries, such as healthcare, are less sensitive to economics cycles, while others are tied more directly to the prevailing economic climate, such as the paper and forestry sector.

Style To top

Style diversification is the process of including a variety of different management syles in the equity section of a portfolio. Different management styles go through periods of outperformance that are usually followed by periods of underperformance. Because it's almost impossible to predict these cycles, a suitable balance of growth and value funds is often the best approach.

Investment Styles

Growth: A management style that focuses on the expected ability of a company to grow its earnings at an above average rate. Growth managers look for a record of strong earnings, evidence of market leadership, and signs that growth will continue or accelerate.

Value: A management style that emphasizes companies priced below their perceived potential value. Value managers will look for low book value and lower price to earnings ratios as an indication that a stock is undervalued. Value managers purchase out-of-favour companies with the expectation that their share price will eventually rise to reflect the company's true value.