When it comes to investing, it’s always a good idea to diversify.
Diversification is the technique of allocating portfolio resources or capital to a mix of investments. The goal of diversification is to reduce the volatility of an investment portfolio by offsetting losses in one asset class with gains in another. “Do not put all your eggs in one basket” is a common expression that captures this idea since having your “eggs” in multiple baskets mitigates risk; if one basket breaks, it won’t break all the eggs.
Beyond simply dividing your assets between stocks and bonds, comprehensive diversification means investing across multiple assets classes, geographic locations, industries, currencies, and markets. That’s because the various asset classes will tend to experience gains or losses at different times within an economic cycle. And since it is impossible to know with certainty at what point an economy is within a market cycle, incorporating comprehensive diversification into a portfolio is the best way to capture market-based returns without taking on undue risk.
Table 1: Who Will Win? – It’s Anybody’s Guess!
As Table 1 illustrates, predicting which asset class will perform in any given year is difficult. The best performing asset class in one year may be the worst-performing one in the next. For instance, who would have guessed that investors who pulled their money out of Canadian Bonds in 2000 would have missed the stellar returns the following year?
While diversification can help an investor manage risk and reduce the volatility, you can never eliminate market risk completely, no matter how diversified your portfolio is. Market risks affect nearly every type of security, so it is also important to diversify among the different asset classes. The goal of diversification is to find a sweet spot between risk and return and let your time in the markets do the rest.
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