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Diversify your investments

We’re often told to diversify our investments. There are several ways of doing so.

You can diversify by:

  • Product: shares, bonds, guaranteed investment certificates (GICs), etc.
  • Stocks: shares of different companies.
  • Financial institution.
  • Region: Canadian and foreign investments. 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.
  • Industry: stocks of natural resources companies, financial institutions, etc.
  • Maturity: guaranteed investments that mature in one year, five years and ten years. Therefore, if interest rates drop, you do not have to reinvest all your investments at lower rates. On the other hand, if interest rates rise, a portion of your portfolio will profit.
  • Currency: investments in Canadian and U.S. dollars, as well as other currencies.

As you can see, there are several ways in which to diversify investments. You don’t have to use all of them, just those that you feel comfortable with. Diversification ensures that your eggs are not all in the same basket. For this strategy to be effective, your investments must not all fluctuate in the same direction at the same time.

For simplification, the hypothetical examples below deal only with diversification through stocks. They show why it’s important to have a diversified portfolio.

Exemple 1

Two pharmaceutical companies 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 goes for it, investing $10,000 in Company A.
There’s a 50% chance that he’ll pocket $2,000, and a 50% chance that he’ll lose $1,000.

John prefers to invest $5,000 in Company A and $5,000 in Company B.
He’ll make $500 either way, or a 5% return. Here’s why:

  • If Company A develops the drug first:
    John makes 20% or $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% or $500 on Company A but makes 20% or $1,000 on Company B, for a net gain of $500.

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

Exemple 2

Sam likes John’s proposed diversification, but feels that he won’t be able to reach his objectives with a 5% return. He believes that Company A will discover the drug first, and is prepared to cope with fluctuations in his holdings in order to increase his potential returns. On the other hand, he’s not ready to risk his capital. He divides his $10,000 investment as follows:

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

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

There’s a 50% chance that Sam will make 10% on his investment, and a 50% chance that he won’t gain or lose anything.