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The nature of diversity

If you stand on tiptoe, you may be temporarily balanced, but you are easy to tip over (hence the name, tip toe). If you get down on all fours, with your hands and knees on the floor, you are also balanced but hard to tip over. That's because your weight is now spread among four places-- you have diversified your balance points.

Investments can work the same way. If you have all your eggs in one investment, you risk tipping over if that investment goes sour. Diversification is the way to reduce your overall investment risk while still meeting your investment objectives.

This is because dissimilar investments react differently to the same market conditions. In times of inflation, for instance, fixed-income investments like bonds may decrease in value while tangible asset investments like gold bullion may soar. Your winners may earn enough to compensate for your losers.

There are several ways to diversify. You can spread your investments among different types of instruments: stocks, bonds, money market funds, precious metals, currency, or real estate. You could diversify within an investment type, such as buying stocks among several different industries, service companies, or financial companies. Your could diversify geographically among North America, Europe, Latin America and the Far East.

For diversification to work best, your investments should be reviewed often. Various investments may suit your needs for a given period of time, but times change. With close personal attention, diversification is one of the best investment strategies you can use.

Diversification has three costs. The first is your time to review your investments on a regular basis. The second is transaction costs you will have to pay to buy or sell in order to adjust your diversification mix. The third is a possibly lower return, as some good and bad investments cancel each other out, in exchange for avoiding disaster.

If you buy $50,000 of the stock of one company and the stock doubles, you are a $50,000 winner. If the stock halves, you are a $25,000 loser. If only 20 per cent of your money is in the stock of this company, you earn $10,000 if it doubles and lose $5000 if it falls to half price. Both your gains and losses are reduced by diversification. In this way, diversification works somewhat like insurance; there is a cost for reducing risk.

However, smart investors are in it for the long run, not the quick profit. They invest for long-term gains. Taking a chance for quick profits is called gambling, not investing.

One way to achieve diversification and reduce your costs is by investing in mutual funds. You reduce the time cost to review your investments by relying on a good fund manager to make short-term decisions while you track the value of the fund semi-annually or annually. You reduce the transaction costs because fund managers receive volume transaction discounts when the fund buys or sells. You can even reduce the "insurance" costs of diversification by choosing a mutual fund that performs above average.

Diversification really blossoms with mutual funds. You could simultaneously diversify by industry and investment type by choosing a Canadian equity fund and a bond fund. Your could diversify by industry, by investment type, and by geography by choosing an international equity fund and an international bond fund. There are mortgage funds, precious metals funds, money market funds, and even sports funds which specifically invest in sports franchises.

Your retirement money, usually within an RRSP, should be diversified. You don't want to gamble too much with your future. But you can still take the occasional flyer on a hot speculative investment outside your RRSP, just be sure it is money you can afford to lose.

The best counsel on how to diversify to reduce your risks while still achieving your goals comes from your financial advisor. Meet with a Fiscal Agent to discuss how best to develop a portfolio mix that is right for you.

Don't be a pushover by always standing on tiptoe to reach the highest gains possible. Sometimes it's better to plod along steadily, shrug off the occasional loss, and reach your investment goals through diversification.

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Companion Advisor
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Why the smart money remains fully invested

Spreading Your Wealth Around

Investing for the Long Term

Home ownership works with borrowed money; investing can too

Market benchmarks

The power of compounding

Derivatives: Not so scary

Finding the money to invest

The nature of diversity

How to analyze risk

Sources of investment information