Many studies illustrate diversification as being the pivotal ingredient to achieving long-term growth with reduced volatility. Interestingly, Jacob Fugger, 15th century banker (whose family grew to control much of the European economy) advised:
“Divide your fortune into four equal parts: stocks, real estate, bonds and gold coins and be prepared to lose on one of them most of the time. Whenever performance differences cause a major imbalance, rebalance your fortunes back to the four equal parts.”
The investment adage instructing us to "avoid putting all our eggs in one basket" has become such a cliché that we are almost embarrassed to mention it. It is, however, an essential starting point to introduce our theme of diversification, if only to point out that this metaphor, while accurate, is a gross oversimplification of a complex concept.
Every investment carries some risk (just as every non-investment carries some risk). Understanding how different risks inter-connect is essential to building a portfolio that is fully diversified and will maximize risk-adjusted returns. Within the world of equities, there are dozens of sectors, many of which are barely represented in Canada. Worldwide, geographic disparities lead to further opportunities for those with the capacity to investigate closely. Complexities in the debt markets are of at least an equal challenge to the equity markets.
In short, spreading portfolio risk across a wide variety of asset classes, geographic regions, investment styles and market capitalizations are an important starting point. Asset allocation must then be reviewed routinely based on a comprehensive outlook for the capital markets in order to maintain an appropriate balance between expected returns and both short-term and long-term risks.