Personal finance is all about devising and implementing strategies surrounding earning, spending, investing, saving and debt. One effective methodology that has stood the test of time is the diversification strategy. These tactics have been used by pretty much everyone concerned with finance from the small business owner to the 9-5 employee to the corporate tycoon. But what is diversification strategy in personal finance? Continue reading to find out!
Table of contents
- What is Diversification Strategy?
- Understanding the Concept of Diversification
- 5 Types of Diversification Strategies
- What are 3 benefits of diversification?
- What are 3 pitfalls of diversification?
- Why is Diversification Strategy Important?
What is Diversification Strategy?
Traditionally, diversification strategy is a term used in business. It is a practice that involves adding products or services with the intention of growing. However, the same concept applies in personal finance. For instance, by expanding the types of income you earn, you’re partaking in a diversification strategy. Or, if you own a variety of investments among different industries and risk levels, then you’re applying the concept of diversification. All in all, if companies can grow their wealth using a diversification strategy, you can do the same!
Whether you’re a seasoned day trader or a long term investor, it’s wise to have some kind of diversification strategy for your personal finances. In essence, a diversification strategy is a part of your approach to personal finances, including saving, earning and investing.
Match to your perfect advisor now.
Getting started is easy, fast and free.
Related Reading: What is Capital Cost Allowance?
Understanding the Concept of Diversification
On a broad level, diversification is a tactic used by companies, investors and personal financiers to ensure they’re not financially dependent on a single source of income. In other words, diversification means don’t put all your eggs in one basket! Diversification is important because, without it, its much more challenging to obtain financial freedom.
Income can be derived from a variety of sources, such as employment, side hustles, investments, and more. When you only have one reliable source of income, you are taking on greater risk. If you were to lose that sole source of income, you may be unable to pay bills, deplete your emergency fund, and generally run into financial trouble. But if you were to have two or three types of income at your disposal and you lost one, the financial impact wouldn’t be as severe.
We’ve seen how diversification applies to income, but what about investments? The same concepts apply. If you were to put all your life savings into one stock and that stock crashed, you may have lost the savings you worked your whole life to earn — at least until the market recovers, but that could take years! For this reason, investors split their money across many types of investments, such as stocks, real estate, guaranteed investment certificates, ETFs, cash reserves and so on. In addition, investors often diversify by risk meaning they invest in low, medium and high risk investments simultaneously. Using this tactic, if a high risk investment tanks, the investor still has low and medium risk investments that won’t be as profitable, but will keep their portfolio afloat.
Finally, those who are self-employed or own a small business can apply diversification strategies to their operations too. In most instances, this involves introducing a new product or service to your existing offerings. Normally this practice increases profit because you already have the resources. Plus the incremental cost is low, while the potential for more profit is high. Furthermore, you won’t have to rely on income from one product or service, but rather many, which is less risky. For instance, if you sell hand-made earrings online, you might want to consider offering hand-made bracelets and necklaces too. Or, if you’re a freelance blog writer, consider offering editing or resume writing services as well.
Related Reading: Best Cryptocurrency ETFs in Canada for 2023
5 Types of Diversification Strategies
Generally speaking, there are five types of diversification strategies that apply to investing and personal finance. Let’s take a closer look below.
Asset Diversification Strategy
This tactic involves spreading investments across various asset classes, usually using percentages. Asset classes are defined by the unique risks and opportunities offered by an investment. Examples of asset classes include stocks, bonds, ETFs, real estate, cash reserves and commodities. The idea is that if one asset class suffers, another asset class will benefit. In this way, you’re reducing your personal finance exposure and risk through asset management.
Geographic Diversification Strategy
When you invest in numerous countries and locations across the world, you’re using a geographic diversification strategy. As much as we love Canada, it’s wise to invest in other companies across the world, perhaps in Europe and the United States. If one country’s economy suffers thereby affecting income and investments, another will thrive because the whole world is interlinked.
Sector Diversification Strategy
This strategy advises you to invest across multiple industries and corporate sizes. For instance, you shouldn’t put all your money into mining, but rather into many sectors, such as mining, energy, retail and more. In addition, you should invest in companies of varying sizes, not just big or small organizations. This way, if one sector suffers, you will protect yourself through diversification.
CIBC Investor’s Edge Offer
CIBC offers a low $6.95 per equity or ETF trade
Income Diversification Strategy
The more sources of income you have, the more financial freedom you’ll have. It’s wise to buy into investments that produce different kinds of income. For example, eligible and non-eligible dividend producing stocks, business income, employment income, passive income, and more. Yes, you may have to put in some work to generate certain kinds of income, but the more streams you have, the better.
Risk Diversification Strategy
Last but not least, risk diversification strategy involves buying into investments at various risks levels. You should spread your investments across high, medium and low risk assets. This way, if a high risk investment fails, you’ll have more stable investments to cover the loss.
Related Reading: Tax Efficient Investing Canada
What are 3 benefits of diversification?
- Lower risk. The main benefit of diversification is reducing risk. You worked hard for your savings, diversification strategies preserve and grow them!
- Stable returns. By using diversification, you can smooth out returns as opposed to cyclical highs and lows. This way, you can rely on your investment income.
- Builds long term wealth. Through diversification strategy usage, you can build your wealth in the long term. Down the road, you’ll be able to retire comfortably or partake in whatever financial freedom means to you!
What are 3 pitfalls of diversification?
- Tax implications. With more profits comes more taxation, unfortunately. If you’re not familiar with how the Canadian tax system works, you might be hit with an unexpected tax bill that will eat into your investing profits.
- Learning. If everyone could become Warren Buffet overnight, they would. The truth is skillful investing involving diversification strategies takes time to learn and master. You might make expensive mistakes along the way.
- Opportunity cost. If one of your investments turns an extreme profit, but you diversified your portfolio, you’re facing an opportunity cost. If you had bought more of that profitable investment, you’d make a lot more money. Ultimately, diversification is a balancing act!
Why is Diversification Strategy Important?
Designing and implementing a diversification strategy into your investments and personal finances will help you reduce risk, stabilize returns and grow your wealth. In addition, diversification strategies are a tried and true method amongst individual investors and mega corporations alike. If you’re trying to expand your wealth and obtain financial freedom, using diversification strategies is a must!