Diversifying investments

Reducing risk is one of the main objectives of diversification. For this strategy to be effective, your investments must not all fluctuate in the same direction at the same time.

Investment categories

There are several ways to diversify your investments. Know that you don’t have to use all of these types of diversification.

The table below shows different ways you can do so.

Maturities

Have guaranteed investments that mature in 1 year, 5 years and 10 years. Therefore, if interest rates drop, you don’t have to reinvest all of your investments at lower rates.

Foreign currency

Have investments in Canadian and U.S. dollars, as well as other currencies.

Financial institutions, fund managers

Allocate assets between two financial institutions; buy funds managed by different firms.

Regions

Not all markets move in the same direction. The Canadian market may be on a downswing, while global markets are performing strongly, or vice versa. Diversification can be achieved through Canadian and foreign investments, for example.

Industries

Own stocks of natural resources companies, financial institutions, consumer goods, etc.

Stocks

Hold shares of different companies.

Types of products

Hold shares, bonds, guaranteed investment certificates (GICs), etc.

Two hypothetical examples of diversification

Here are two hypothetical examples to help you understand how you can diversify through stocks.

Hypothetical example 1 – An investment with and without diversification

Two pharmaceutical companies (A and B) are conducting extensive drug discovery research. The company that develops the drug first will generate a 20% return for investors, while the company that doesn't succeed will incur losses of 10%.

Let's assume that the two companies have an equal chance of developing the drug.

Peter and John each have $10,000 to invest.

Hypothetical example without diversification

Hypothetical example with diversification

Peter invests the entire $10,000 in Company A.


There’s a 50% chance that Peter will make a 20% profit ($2,000), and a 50% chance that he’ll lose 10% ($1,000).

John prefers to invest $5,000 in Company A and $5,000 in Company B.


Whatever happens in this theoretical example, he is sure to make $500, or a 5% return. Here's why:

  • If Company A markets the drug first:
    John makes 20% ($1,000) on his $5,000 investment but loses 10% on Company B, or $500. That leaves him with $500.
     
  • If Company B wins the race:
    John loses 10% ($500) on Company A but makes 20% ($1,000) on Company B, for a net gain of $500.
 

This hypothetical example shows how diversification can help you reduce the overall risk of your investments.

Hypothetical example 2 – Diversify for a higher return

Sam likes John’s proposed diversification, but feels that a 5% return won’t allow him to reach his objectives.

He thinks that Company A will discover the drug first. However, he’s willing to risk a drop in his investments on the chance that they’ll bounce back even higher. On the other hand, he’s not ready to risk all of his capital.

So, he splits up his $10,000 investment as follows:

He invests $6,667 in Company A and $3,333 in Company B.

  • If Company A markets the drug first:
    Sam makes 20% ($1,333) on his $6,667 investment but loses 10% on Company B ($333). That leaves him with a total profit of $1,000, or a 10% return.
     
  • If Company B wins the race:
    Sam loses 10% ($667) with Company A but makes 20% ($667) with Company B. So he doesn’t gain or lose.

With this hypothetical example, there's a 50% chance that Sam will make 10% on his investment, and a 50% chance that he’ll come out even.

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