Diversifying Your Portfolio: Understanding Asset Classes

Diversification might sound like a financial buzzword, but it is key to building a healthy and resilient investment portfolio. Instead of putting all your financial eggs in one basket, diversification involves spreading your investments across different asset classes to mitigate risk and enhance overall returns. Diversifying where you are investing your money is particularly important for business owners and professionals like dentists. While it can be tempting to put all your financial resources into growing your business and advancing your career, that may leave you open to risks out of your control and put your personal financial goals in jeopardy.

Understanding asset classes

Diversification starts with understanding your investment options. Individual investors have access to a variety of asset classes to build a diversified investment portfolio. Here are some of the main asset classes available:

Equities (Stocks)
  • Ownership shares of publicly traded companies.
  • Provide the potential for significant investment growth and may distribute a regular dividend payment to shareholders.
  • Carry the risks of volatility and losses.
Fixed-Income Bonds
  • Debt securities issued by governments, municipalities, or corporations with set rates and fixed maturities.
  • Carry some risk, but generally provide more security than stocks and other more volatile asset classes.
  • Despite having fixed terms, bonds can be traded on markets.
Real Estate
  • Includes owning a residential or commercial property for personal use or as income-generating property.
  • Real Estate Investment Trusts or REITs offer investors a way to invest in real estate without the need to own and operate a property.
  • Physical goods or raw materials such as gold, silver, oil, or agricultural products.
  • Often accessed through commodity exchange-traded funds (ETFs), futures contracts, or commodity-focused mutual funds.
  • Commodities markets can be volatile and therefore add risk to a portfolio.
Foreign Currencies
  • Useful for those who travel frequently, maintain residences abroad, or engage in cross-border commerce.
  • Forex (foreign exchange) trading can help manage geopolitical risks.
  • ETFs and mutual funds provide opportunities to invest in foreign currencies without owning them.
  • Holding cash or cash equivalents (like GICs and money market mutual funds) is important for maintaining short-term liquidity and managing risk levels.

Other asset classes include cryptocurrencies, such as Bitcoin and Ethereum, private equity and venture capital where investors buy stakes in early-stage and privately held companies, and collectibles like fine art, rare coins, or vintage cars. In general, these classes of investment are highly speculative, require much higher initial investments, and carry more risk.

Allocating your assets

In a diversified portfolio, each asset class contributes to your overall returns, and the risk associated with any individual investment is offset. If one asset class underperforms, the others may still provide stability or growth. For example, during a period of economic growth, stocks and commodities may offer high returns, while bonds and REITs could act as a buffer if the stock market experiences a downturn. Conversely, in a more challenging economic environment, the stability of bonds and the income generated by REITs may offset potential losses in the stock market.

Imagine you have $50,000 to invest, and you're considering allocating it across the following asset classes: stocks, fixed income, real estate, commodities, and cash. Here's how a diversified portfolio might look:

Diagram Asset Allocation

Diversification isn’t just about spreading investments across different asset classes; it also involves diversifying within each asset class. For stocks, a diversified investor could own shares in companies from various industrial sectors or geographic regions. In bonds, investors can diversify across different types of issuers and varying maturities (see our article on laddering). Mutual funds and ETFs give investors access to all these asset classes for those who prefer not to own any individual stock, bond, REIT, or commodity.

Benefits beyond diversity

The benefits of portfolio diversification extend beyond risk mitigation. Over time, an efficiently allocated portfolio can enhance long-term returns by capturing opportunities across different market conditions. Whether you're a seasoned investor or just starting, diversification is a principle that can work for everyone. By diversifying your portfolio, you're taking a proactive step toward financial resilience and optimizing your investment potential.

If you'd like personalized guidance on building a diversified portfolio tailored to your financial goals and risk tolerance, a Certified Financial Planner® professional at CDSPI Advisory Services Inc. can help. Schedule a meeting to begin the conversation about enhancing your investment strategy and securing your financial future.