How Diversification Can Reduce Investment Risk

16.3 How Diversification Can Reduce Investment Risk

You’ve probably heard the saying, “Don’t put all your eggs in one basket.” That’s essentially what diversification is about—spreading your investments across different assets, industries, and regions so if one segment of the market runs into trouble, your entire portfolio doesn’t collapse like a house of cards. It’s a core concept in investment management, firmly rooted in modern portfolio theory, but it’s also just plain old common sense. When you choose to diversify, you’re reducing the impact that any single security, industry, or even country can have on your overall results.

Below, we’ll dive into exactly how diversification helps mitigate risk, the role of correlation in building a diversified portfolio, and the importance of balancing strategic and tactical asset allocation. I’ll also share a small personal anecdote along the way—and, oh, we’ll have a fun example you can wrap your head around. Let’s jump in.

Defining Diversification

Diversification is the intentional process of investing your money across multiple asset classes—such as equities, bonds, real estate, and alternative investments—and even different geographical regions. By doing this, you mitigate the risk that one specific downturn, whether it’s an industry-wide meltdown or a regional economic crisis, will sink your investment ship.

• When you hold just one stock (say, a tech giant), you’re fully exposed to that company’s fortunes. If it underperforms or faces scandals, your entire portfolio suffers.
• By adding other types of stocks (like consumer staples or utilities), plus fixed income instruments (like government or corporate bonds), real estate, or commodities, you dilute each asset’s influence on your total wealth.

In a nutshell, diversification isn’t guaranteeing profits—it’s safeguarding against catastrophic losses. Over the long run, that’s a much better place to be.

Unsystematic Risk and Systematic Risk

In finance, risk is often split into two big buckets:

• Systematic Risk: Also called market risk, it’s the type of risk that impacts the entire market—like broad economic recessions, changes in interest rates, or global political crises.
• Unsystematic Risk: Also called company- or sector-specific risk, it’s tied to a particular firm, industry, or region. Think of a scandal plaguing a specific corporation or a local flood impacting agricultural land in one province.

Diversification mostly helps you tackle unsystematic risk. By spreading your funds across various industries or regions, you reduce the likelihood that any single hazard will send your portfolio into free fall. However, when the entire market dips because of a severe recession, diversification won’t completely shield you—but it can still cushion you somewhat if certain sectors or asset classes are less impacted than others.

The Magic of Correlation

Now, let’s talk about correlation, which is basically the degree to which two assets move in tandem. Correlation can range from -1.0 to +1.0:

• A correlation of +1.0 means two assets move perfectly in lockstep.
• A correlation of -1.0 means they move exactly in opposite directions.
• A correlation of 0 means there’s no relationship at all—their movements are independent.

When you choose assets whose prices aren’t highly correlated (ideally, near 0 or even negative), you get better risk reduction from diversification. For example, if tech stocks tend to move in the opposite direction of certain commodity-focused stocks, combining these two can stabilize your overall returns.

If, on the other hand, you pack your portfolio entirely with assets that are closely correlated (like a bunch of banks in the same region), you won’t get true diversification benefits. If one bank goes down, there’s a good chance the others might be dragged down too, because they’re all susceptible to the same economic factors (like interest rates, borrowing demand, etc.).

A Simple Example: Adding Consumer Staples

Imagine you have a portfolio that invests solely in technology stocks. Let’s say your entire $10,000 is in a single tech ETF. If the tech sector plunges by 20% next week, your portfolio is now worth $8,000. That’s a tough pill to swallow.

What if you spread out that $10,000 between tech stocks, consumer staples, and a broad market bond fund? Say, $4,000 in tech, $3,000 in consumer staples, and $3,000 in bonds. If tech still plunges by 20%, you now lose $800 on that portion, dropping its value to $3,200. But consumer staples might be unaffected or could even rise a bit, and bonds might stay steady or inch up if interest rates remain stable. Your total losses, then, might be much smaller. The difference here is correlation: consumer staples and bonds may not march alongside tech’s ups and downs.

Sure, you might miss out on some huge tech rally if you don’t put every cent in that sector, but you also avoid the brutal downturns that can knock you back to square one. Over time, diversification aims to smooth out returns so you can stomach the inevitable dips more easily.

Over-Diversification

Sometimes, you can take diversification too far—what’s often called “diworsification.” If you hold 300 different stocks from every sector on Earth, your portfolio might just mimic a global index. That can be fine if that’s your strategy, but you might lose the benefits of any superior picks. Also, your management time and transaction costs can go up, with minimal incremental gains in risk management.

Strategic vs. Tactical Asset Allocation

• Strategic Asset Allocation: This is your long-term, policy-based approach. Picture it like setting the big puzzle pieces of your portfolio. You might decide, for instance, you want 60% equities, 30% fixed income, and 10% alternative investments (like real estate or commodities). This broad allocation typically remains steady, adjusting only as your financial goals and risk tolerance evolve over time.

• Tactical Asset Allocation: This is more short-term and opportunity-based. If you spot a potential hot streak in emerging market equities, you may shift an extra 5% of your assets there on a temporary basis. Conversely, if you foresee a big correction in a particular sector, you might pare down that exposure. While strategic allocation sets the open-sea course, tactical allocation is like making small course corrections when you see a storm or find a shortcut.

Combining both can allow you to maintain a stable diversification foundation while still taking advantage of potential market opportunities.

Global Diversification

Spreading your investments across different geographical regions is another way to diversify. If the Canadian economy hits a rough patch, other regions (like parts of Europe or Asia) may not be affected to the same extent. That said, global diversification isn’t without its own twists:

• Currency risk: Changes in exchange rates can either boost or erode returns.
• Geopolitical risk: Emerging markets might have political or regulatory frameworks that are less stable than those in mature markets.
• Different economic cycles: Certain regions can lag behind or move ahead, which can be either beneficial or detrimental to your portfolio at different times.

So, yes, you reduce local or region-specific vulnerabilities, but you do add complexities like currency fluctuation and potential geopolitical upheavals. In Canada, many advisors suggest that while global diversification is good, it must be implemented carefully, sometimes using hedged products or carefully sized allocations to manage currency volatility.

Diagram: The Diversification Flow

Below is a simple diagram illustrating how a single-asset portfolio can transition into a diversified one, reducing overall risk exposure:

    flowchart LR
	    A["Single Asset <br/>Portfolio"] --> B["Add Different <br/>Sectors"]
	    B --> C["Add Different <br/>Asset Classes"]
	    C --> D["Incorporate Global <br/>Exposure"]
	    D --> E["Diversified <br/>Portfolio"]

In this flow, each step broadens the investment scope, thereby reducing the impact of a downturn in any one area.

Canadian Regulatory Considerations

If you’re a Canadian advisor (or working with Canadians), you’ll want to stay in line with the guidance from the Canadian Investment Regulatory Organization (CIRO), which, as of January 1, 2023, is the consolidated self-regulatory body overseeing investment dealers and mutual fund dealers. CIRO emphasizes suitability and ensuring you’re building an appropriate diversified portfolio that matches a client’s risk tolerance, objectives, and time horizon.

The Canadian Securities Administrators (CSA) also have rules on mutual funds and Exchange-Traded Funds (ETFs). These funds can be pre-diversified by design, which is especially popular with smaller portfolios. Meanwhile, the Canadian Investor Protection Fund (CIPF) provides coverage if your advisor’s firm goes insolvent; however, it won’t protect you from market losses—that’s essentially what diversification is for.

Practical Tools for Monitoring Diversification

Several online tools can help you see how diversified your portfolio really is:

• Portfolio Visualizer
• Morningstar’s Portfolio X-Ray
• Broker-based risk analytics tools that show sector concentration, correlation metrics, and geographic exposure

These can reveal hidden concentrations—like finding out you only thought you had 30 stocks, but you actually have a big chunk in a single sector or region.

Case Study: My First Attempt at Diversification

Years ago, I helped a close friend set up his first investment account. He was super excited about a specific cannabis stock boom in Canada—but that was a very narrow bet. We added a consumer staples ETF, some broad Canadian market exposure, and a few GICs (Guaranteed Investment Certificates) for stability. When the cannabis stocks tumbled shortly afterward, my friend was disappointed about that slice but was relieved his entire portfolio didn’t nosedive. He actually thanked me for “not letting him go all-in on that one big idea,” so yes, diversification was the hero of that story.

Balancing Act: Avoiding Pitfalls

1. Over-Diversification: Having too many holdings might lead to negligible risk reduction and increased complexity (more fees, potential overlap in holdings).
2. Complacency: Diversification doesn’t mean you can “set it and forget it.” You need to monitor correlations that change over time, even among asset classes that used to be uncorrelated.
3. Chasing Returns: Don’t panic-buy or sell based on short-term market movements. Stick to your strategy unless your personal circumstances or market fundamentals require an update.

Sample Formula: Portfolio Variance

A simplified way to see how correlation affects your overall risk is by looking at the formula for the variance of a two-asset portfolio:

Where:

• \( \sigma_p^2 \) is the variance of the portfolio,
• \( w_1 \) and \( w_2 \) are the weights of asset 1 and asset 2,
• \( \sigma_1 \) and \( \sigma_2 \) are the standard deviations of asset 1 and asset 2,
• \( \rho_{1,2} \) is the correlation coefficient between asset 1 and asset 2.

If \( \rho_{1,2} \) is low or negative, the variance of the combined portfolio can become significantly lower than the sum of individual variances—showcasing the power of diversification.

References for Further Exploration

• CIRO (Canada’s self-regulatory organization): https://www.ciro.ca
• CSA’s rules on mutual funds and ETFs: https://www.securities-administrators.ca
• Portfolio Visualizer: https://www.portfoliovisualizer.com
• Morningstar’s Portfolio X-Ray: https://www.morningstar.ca
• Gibson, R. C., “Asset Allocation: Balancing Financial Risk”
• Bernstein, W. J., “The Four Pillars of Investing”
• Online courses on Coursera or edX for asset allocation fundamentals

Key Terms

• Diversification: Spreading investments to reduce exposure to any single asset’s volatility.
• Correlation Coefficient: A measure showing how two asset prices move in relation to each other, between -1.0 and +1.0.
• Strategic Asset Allocation: A long-term, fixed approach assigning target percentages to different asset classes.
• Tactical Asset Allocation: A short-term, more flexible approach designed to capitalize on specific market conditions.
• Sector Risk: The possibility of loss arising from factors affecting a specific sector (e.g., financials, energy).
• Asset Class: A group of securities with similar characteristics and market behaviors (equities, fixed income, etc.).
• Over-Diversification: Holding so many assets that the marginal benefit of risk reduction becomes minimal.
• Global Diversification: Investing across different regions of the world to reduce local market risk.

In the end, diversification is about being proactive in protecting yourself from unpredictable events. You want to maximize the potential for stable, consistent growth over time, and that usually means mixing it up so one bad day in a single sector doesn’t eliminate years of gains.

Test Your Knowledge: Diversification and Investment Risk