Lower investment risk by diversifying

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People have interesting perspectives when it comes to lowering investment risk through diversification. Diversification is one way of saying don’t put all your eggs in one basket.

Canadians are often conservative, so risk management comes naturally. We lower the risk of financial loss by buying insurance policies on everything from our automobiles and houses to the loss of income or life. To protect ourselves against loss, we’re willing to pay insurance premiums.

When it comes to investing, our natural risk aversion tendencies often get left behind.

Many investment portfolios are too concentrated. The single largest diversification mistake I’ve noticed is for an investor to have most of their investment assets located in Canada. Canada represents a mere three per cent of the world economic activity, yet many investors have most of their investments in Canada.

From a diversification point of view that is a mistake. The Canadian markets are overly concentrated in the financial sector or natural resources.

The investment vehicle of choice for many is investing in mutual funds. Some investors diversify their portfolio by owning several different mutual funds.

The irony is most of those mutual funds own the same underlying financial and resource companies. The investor thinks they have diversification but in actual fact, they don’t.

Fewer people hold individual stocks directly and when they do, their holdings are often concentrated. When they think they have invested in a good firm their confidence may incline them to overweight that investment.

If you win you want to win big. Unfortunately, that flies in the face of prudent risk management through diversification.

You may not be able to control how the stock market will perform but that’s the risk you accept when you invest.

The good news is, you do control how much diversification you have within your investment portfolio. That is an extremely useful way to manage normal investment risk.

 

 

Peter Watson is an agent of, and securities products are provided by, Aligned Capital Partners Inc. (ACPI).  ACPI is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Investor Protection Fund (CIPF).  The opinions expressed are those of the author and not necessarily those of ACPI. Peter Watson provides wealth management services through Peter Watson Investments.