All investments bring with them a level of risk because so many factors, from politics to tsunamis, labour strife and pandemics can send stocks tumbling.
That’s to say nothing of new get-rich-quick technologies and products that tempt investors into even more uncertainty by encouraging them to play in high-risk, high-reward territory. That’s why diversification — investing in different asset classes and choosing the stocks of companies that operate in different sectors — is key to successful long-term investing.
It’s essentially the safety net that helps shield investors from losing everything should the worst case scenario occur.
“Diversification plays an important role in helping you avoid the noise of the market,” says Asif Khan, a wealth advisor with BMO Private Wealth.
He compares an investment portfolio to a bundle of pencils: if you have only five, you can easily break them. But with 50 pencils in the investment bundle, “it becomes harder… maybe a few will crack.”
Being a successful investor, Khan adds, is about “being long-term goal-focused, not short-term performance-driven.” Any new investor would be wise to ignore the buzz around today’s hot tips and focus on slower, long-term growth.
Beyond simply buying stocks in different types of companies, diversification also relates to the idea of asset allocation, says Eric Kirzner, Professor Emeritus of Finance and John H. Watson Chair in Value Investing at the Rotman School of Management. Asset allocation, he says, is the “mix between safety income and growth investments.”
Kirzner says a healthy asset allocation will likely include 20% in safety income, 40% in fixed-income investments and 40% in growth investments.
“The asset allocation is the first key to diversification,” he says.
A young investor might simply start with a high-interest savings account to build up some capital, he suggests. “The next $1,000 might go into a stock — probably an Exchange Traded Fund.” Often referred to as an ETF, its performance is based on the performance of a collection of stocks that are the underlying investments in a vehicle like XIU, which includes many of the top Canadian companies.
“That in itself is diversified,” he says.
Ultimately, “anything that looks too good to be true is too good to be true,” says Kirzner.
“There is no free lunch, and there’s nothing that can overcome knowledge.”