Diversification entails reducing risk by investing in different asset classes (groupings of investments with similar characteristics, for example, stocks and bonds), industries, geographical regions and other groups. Instead of placing all your money in a single stock or sector, you diversify your holdings so that a loss in one area may not have a significant impact or may even be offset by gains in another part of your portfolio. This strategy helps protect your portfolio from volatility and can lead to more stable investment growth over time.
In this article, we’ll explore the full meaning of diversification, explain why it’s crucial for every investor and walk through the different ways you can create a diversified portfolio. We'll also look at the pros and cons of diversification and give practical advice on how to start.
What is diversification in investing?
The adage, “Don’t put all your eggs in one basket” sums up diversification. By spreading your eggs over numerous baskets, you reduce the risk of breaking all of them. Diversification is similar; it involves allocating your capital across a range of investments that don’t all behave the same way under the same market conditions. The goal is not to completely avoid risk (no investment is completely safe, and riskier assets typically bring higher returns) but to manage and reduce the impact of volatility on your portfolio.
For example, if you were to invest only in U.S. technology stocks, and the tech sector experienced a sharp downturn, your portfolio could suffer significant losses. But if you also held bonds, real estate and international stocks, those other assets may hold their value or even increase, helping to cushion the blow.
Why diversification is so important
Diversification acts as a crucial risk management strategy. All investments have some degree of risk, whether it’s market risk, interest rate risk, inflation risk (when inflation makes your investments less valuable) or company-specific risk. Diversification helps mitigate these risks by ensuring your portfolio isn’t overly dependent on the performance of any single investment or sector.
Let’s consider a real-world example. In 2008, the global financial crisis caused the collapse of Lehman Brothers, brought large dips in stock markets worldwide and caused a recession in many countries. Many investors who had all their money in financial sector stocks or real estate-related assets suffered huge losses.
But those with a diversified portfolio — which included other sectors, international equities and bonds — experienced less dramatic declines and were in a better position to recover when markets rebounded.
The tech bubble of 2000 is another example. Technology stocks took a nosedive, leaving investors with heavy concentrations in tech to experience large losses. Those who had diversified their holdings across other sectors, such as health care, utilities and energy, or had diversified globally, were better insulated from the worst of the losses.
A well-diversified portfolio can provide peace of mind during market volatility. While some parts of your portfolio may underperform, others may hold steady or even gain. This allows you to stay focused on your long-term strategy instead of reacting to short-term market fluctuations.
Inflation protection is another compelling reason to diversify. Inflation can diminish the purchasing power of cash over time. However, by diversifying beyond cash or GICs, by investing in stocks, real estate and commodities (which typically rise in value at a higher rate than inflation), the appreciation of your portfolio has a better chance of outpacing inflation.
Diversification also helps to align your investments with your risk tolerance level and overall financial goals. A young investor saving for retirement may be more comfortable with higher risk and focus on growth assets. Someone nearing retirement, however, may prioritize capital preservation and income. Diversification allows you to build a portfolio that reflects your personal timeline, goals and comfort with risk.
Diversification is not just a defensive tactic; it’s a proactive strategy for building resilient, long-term wealth.
How to diversify your portfolio
Now that we’ve discussed the meaning of diversification and its importance, let’s dig deeper into how to go about doing it successfully. There are a number of ways to diversify your portfolio, and the more you use, the more comprehensively diversified your portfolio will be.
The following are the most common ways to diversify your investments.
Diversification through asset classes (investment types)
Each type of asset often behaves differently from each other under various economic conditions, and holding a variety of them can help smooth out your returns.
Stocks: these represent ownership in publicly traded companies (and are often referred to as equities). When you buy a stock, you’re buying a small piece of a company and may benefit from its growth through capital appreciation and dividends.
While stocks have the potential to offer higher long-term returns than many other asset classes, they’re also prone to greater volatility. A sharp market downturn can lead to significant short-term losses. However, for decades, equities have historically outperformed other investments over the long term.
Bonds: when you invest in a bond, you’re basically lending money in exchange for regular interest payments and the return of principal when the bond matures. These are often seen as safer investments than stocks and offer predictable income. Government bonds are considered particularly safe, as well as highly rated corporate bonds (these are bonds from companies with high credit ratings, with AAA being the highest).
On the other end of the scale, high-yield (or junk) bonds are considered the riskiest, but can provide the highest returns. In general, bonds tend to hold up well when stock markets take a dip, which makes them so valuable for diversification.
Real estate: this can include homes, commercial property and farmland, and can generate income through rent or increased value. Real estate can be a good way to combat the effects of inflation and also typically moves independently of the stock market.
For most individual investors, the easiest way to access real estate is through real estate investment trusts (REITs), which provide you with exposure to real estate without the need to become a landlord.
Exchange-traded funds (ETFs) and mutual funds: these are collections of securities like stocks, bonds or commodities. Mutual funds are bought either through a financial advisor or through the mutual fund company directly. ETFs are traded on stock exchanges, like individual stocks.
These funds offer instant diversification, because each fund holds a wide range of underlying assets. For example, an S&P 500 Index mutual fund or ETF could hold shares in 500 of the largest U.S. companies. A global bond mutual fund or ETF might include hundreds of bonds from different countries and sectors.
Commodities: these are the raw materials that form the building blocks of production, such as gold, oil, wheat and copper. They tend to perform well during periods of high inflation, because their prices often rise when the cost of goods increases.
Gold is often considered a “safe haven” asset during times of market volatility or geopolitical uncertainty. A modest allocation to commodity-based ETFs or mutual funds can greatly enhance your portfolio’s diversification.
Cash and short-term cash equivalents: these include highly liquid, low-risk investments, such as Treasury bills, guaranteed investment certificates and money market funds. These offer safety and liquidity (they can quickly be turned to cash) but with low returns (often below inflation).
However, holding some cash is important for emergency funds and short-term goals. It can help you avoid selling stocks or bonds during market downturns when prices are low and locking in losses.
Diversification through industry or sector
Within single asset classes, such as stocks, there can be concentration risk; if your stock investments are heavily weighted in technology companies, for example, your portfolio could be vulnerable during a tech sector downturn, regardless of the broader market's performance.
The major sectors include:
- Information technology.
- Financials (banks, etc.).
- Energy.
- Consumer staples (for example, food and household goods).
- Health care.
- Industrials.
- Consumer discretionary (for example, travel and luxury goods).
- Utilities.
- Materials.
- Real estate.
Each sector can react differently to different economic cycles. For example, consumer staples tend to perform better during a market downturn, whereas consumer discretionary stocks usually perform better when the market is on an upward trajectory.
Diversification through geographical region
One of the most effective — and often overlooked — ways to diversify is through investing in different geographical regions. Many Canadian investors, for example, have a strong home bias, meaning they invest heavily in Canadian stocks. While that makes sense on some level (because of familiarity with the names, currency stability and tax benefits), it can leave them vulnerable to country-specific risks.
The Canadian economy is heavily reliant on the financial sector and commodities, such as banks, oil and natural gas. Therefore, when oil prices decline, Canadian equities, particularly in the energy and financial sectors, can be adversely affected.
Reducing reliance on any single region can be achieved by adding exposure to stocks and bonds from U.S., European, emerging market and Asian economies. The U.S. market, for instance, is home to many of the world’s largest tech companies (like Apple, Microsoft and Amazon), which have driven significant global growth over the past decade. Emerging markets, while more volatile, offer high-growth potential in countries like India, Brazil and Vietnam.
By diversifying across regions, you can balance out the possible risks; underperformance in one region — due to political instability or economic changes — may be offset by growth in other regions.
Diversification through growth and value stocks
Balancing growth and value stocks is another way to diversify the equities in your portfolio.
Growth stocks are companies with the potential to grow faster than the average company. They often operate in dynamic sectors, such as technology, biotech or renewable energy. Typically, they reinvest earnings rather than pay dividends, which can result in high returns from capital gains but can also have greater volatility. Microsoft, Apple and Tesla are examples of growth stocks.
Value stocks are shares that appear undervalued when based on fundamentals, like earnings, dividends or market value. These are often established companies in mature industries — such as banks, utilities or consumer staples — that typically pay consistent dividends and are seen as more stable.
These two types of stocks typically perform differently during different economic cycles. For example, growth stocks usually perform well when markets are flying high, while value stocks perform better during market downturns.
Diversification through company size
Another way to diversify your portfolio is by investing in differently sized companies (small caps, mid caps and large caps). Each of these categories can perform differently from each other, depending on the market cycle. Including all three can help balance your exposure across the market spectrum.
Small caps are companies with a market capitalization (the total value of their stocks that trade on the stock market) ranging from $300 million to $2 billion. These companies often have the potential for rapid growth and can also deliver strong returns. However, this higher return potential comes with greater volatility and risk.
Small cap stocks can be a good choice for investors who have a longer time horizon and are more willing to take risks for higher potential returns. Their performance often moves independently of large-cap stocks, which helps reduce correlation and improve overall portfolio resilience.
Mid caps — often seen as the “sweet spot” between growth and stability — typically have a market capitalization ranging from $2 billion to $10 billion. These firms have usually moved past the early start-up phase and have established business models but still have room to grow. They tend to be less volatile than small cap stocks but may still outperform large cap stocks over time.
Large caps are shares of well-established companies with market capitalizations exceeding $10 billion. These are typically mature companies and are industry leaders with strong balance sheets, global reach and consistent revenue. They tend to experience less volatility compared to smaller companies, due to their size and stability, and often pay regular dividends, making them attractive to income-focused investors. While their growth rates may be more modest, large cap stocks tend to perform reliably over the long term.
By including a mix of small, mid and large cap stocks, you’ll not only spread your risk, but you’ll also benefit from different phases of the economic cycle; small caps often thrive during early recovery periods; mid caps grow steadily through expansions; and large caps provide stability during downturns.
Diversification through alternative investments
Looking beyond traditional asset classes (for example, stocks and bonds) can provide even greater diversification. This is where alternative investments can help. They include assets like private credit, private debt and infrastructure. They can offer unique return drivers, much lower correlation with public markets and the potential for stronger risk-adjusted returns.
Let’s break down how each of these alternative investments can help diversify your portfolio.
Private credit consists of loans provided directly to non-public companies (those whose shares are not traded on stock exchanges). These loans typically offer higher yields than publicly traded bonds but they’re less liquid and require a longer investment timeframe.
Private credit has low correlation with stock markets; because private loans are negotiated individually and not traded, their valuations are less sensitive to stock market swings. This makes private credit a powerful tool for diversifying a portfolio.
Private equity investments involve the ownership of companies that are not traded on the stock market and usually carried out through private equity firms. These firms pool investors’ money, then invest in lesser-known companies with the potential for high growth. The private equity firm then uses its expertise to improve those companies’ operations, expand their markets and make more money. They may then sell the companies through an initial public offering or directly to interested buyers. They may also hold them as income-generating investments.
Private infrastructure assets are typically essential projects, such as roads, bridges, pipelines, airports, renewable energy and water utilities. Private investors can fund infrastructure projects and receive returns through dividends, profit sharing and the sale of assets.
These alternative investments can provide greater diversification through having low correlation with other assets, and also provide a regular income stream, which can be especially useful during stock market volatility. You can find out more about private investments here.
Diversification through risk level
Different types of investments come with different levels of risk; some assets are inherently more volatile, while others are more stable. Understanding these risk levels can help you build a more diversified portfolio that matches your financial goals and comfort level with risk. Let’s take a look at a risk spectrum breakdown:
Low-risk investments: these include government bonds, investment-grade corporate bonds, guaranteed investment certificates and savings accounts. While these options can protect your capital, they may not grow your wealth significantly over the long term, especially when accounting for inflation.
Medium-risk investments: these could include blue-chip stocks (shares in large, well-established and typically financially secure companies, like banks and major retailers) and index mutual funds and ETFs (funds that contain shares from companies in indices such as the S&P 500 and S&P/TSX)
High-risk investments: these may include small cap and growth stocks, emerging market investments, cryptocurrencies and derivatives, such as options and futures (sophisticated financial instruments that allow investors to speculate on share price movements). While high-risk investments can significantly boost returns, they can also wipe out gains quickly if things go wrong.
The pros and cons of diversification
While diversification is typically recommended for most investors, it does come with its own set of advantages and disadvantages. Understanding these can help you decide how much to diversify and in what ways.
Advantages of diversification:
Protection from market volatility: diversification can certainly help mitigate the effects of market swings. When one part of your portfolio declines, another may rise or hold steady, balancing out the overall performance. For example, in 2022, many tech stocks saw significant declines as interest rates climbed. But investors who also held value stocks, energy stocks or inflation-protected bonds likely saw less severe declines.
Reducing risk without sacrificing returns: a well-diversified portfolio can provide similar long-term returns to those that are more concentrated, but with much less risk and typically considerably less volatility. The trick is to allocate investments across uncorrelated assets (those that don’t move in tandem with market shifts or each other).
Access to global opportunities: comprehensive diversification includes international investments, which can provide additional growth opportunities that you wouldn’t find with North American stocks.
Disadvantages of diversification:
Limited growth per asset: some investors like to maximize short-term returns by investing in one or two stocks or sectors that they believe will see large and rapid growth. A specific stock or sector would only make up a small part of a well-diversified portfolio.
Potentially higher taxes: if you hold your investments in a taxable account, rather than a tax-free or tax-deferred account (such as a TFSA or an RESP) certain assets have higher tax implications than others. For example, interest from bonds and GICs is taxed higher than income from dividends from Canadian companies or capital gains.
Therefore, for example, a fully diversified portfolio might bring about a higher tax bill than one containing only equities. Many investors may feel that this is a small price to pay for a more secure portfolio.
Help with getting started with diversification
Your IG Advisor will work with you to build an investment portfolio that’s fully diversified to match your financial situation (for example, the length of time before you need to withdraw some of the money invested and the types of investments you’ll need to invest in to reach your goals).
Talk to your IG Advisor to discuss diversification in your portfolio. If you don’t have an IG Advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Advisor. Trademarks, including IG Wealth Management and IG Private Wealth Management, are owned by IGM Financial Inc. and licensed to subsidiary corporations.
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