Why diversification in investing is important for your clients

Diversification is one of the most important principles in investing. It means spreading money across different assets, sectors, and regions instead of relying on a single investment. It can help reduce risk and create stability during uncertain market conditions. 

But while many see it as a cornerstone of portfolio strategy, diversification also has some drawbacks that are worth considering. For instance, it can add complexity or even increase costs. 

Want to see some of its advantages and disadvantages to help you understand how your clients can leverage this strategy? In this article, Wealth Professional Canada will explore what you need to know about diversification in investing. 

What diversification means in investing 

As mentioned above, diversification means spreading investments across different assets so that risk is not concentrated in a single place. When a portfolio is diversified, poor performance in one area can be offset by gains in another. This helps stabilize returns over time. Diversification is not a guarantee against loss, but it makes the portfolio more resilient. 

In simple terms, diversification avoids putting all the eggs in one basket. For example, a client who owns only domestic bank stocks would be exposed to sector risk and market risk. If the Canadian banks face headwinds, the entire portfolio will decline. 

A more diversified investor might hold a mix of these instead of just one type of investment vehicle: 

• individual securities 
• mutual funds 
• exchange-traded funds (ETFs) 
• government bonds 
• real estate investment trusts (REITs) 
• alternative assets 

This variety spreads out the exposure and balances potential outcomes. 

Watch this video to find out how your clients can leverage diversification when building their portfolios: 

Why diversification matters for your clients 

Diversification is especially important in Canada because of the structure of the domestic market. The Canadian equity market is heavily concentrated in financial services, energy, and materials. These three sectors represent more than two thirds of the Toronto Stock Exchange composite index. That means an investor who relies only on Canadian equities faces concentration risk. 

Investors are also influenced by the value of the Canadian dollar. The same is true for interest rate changes and the price of commodities. These factors add volatility. A diversified portfolio helps reduce the impact of these risks by including assets from different countries, sectors, and categories. 

Your clients would trust you more if you can give them the assurance that their investments are not vulnerable to sudden downturns. A well-diversified portfolio is likely to provide them that assurance. 

Is diversification high risk? 

Diversification is not considered high risk. In fact, it is one of the most effective ways to lower risk. A concentrated portfolio exposes an investor to losses if that one investment fails. On the other hand, diversification can provide protection by making sure that no single investment determines overall results. 

Still, it doesn’t remove all risk, since markets always fluctuate, but it makes the journey smoother. For most investors, especially those focused on long-term goals, diversification is a practical strategy that combines risk management with the potential for steady returns. 

Timeline and diversification strategy for investors 

Diversification must also align with your clients’ timeframe. Younger investors with decades until retirement might accept more equity exposure. As such, their portfolios should focus on growth with some diversification into bonds and alternatives for stability. 

As for those who are nearing retirement, they’ll need more predictable income. For these clients, diversification should involve a greater share of bonds and dividend-paying equities. Plus, they can go for annuities. Liquidity also becomes a factor since they will need access to cash for living expenses. 

Want to become a credible financial advisor like those who made it to our 5-Star Advisors list? Keep sharpening your strategies and show your clients how diversification can support their goals at every stage of life. 

Common misconceptions about diversification 

Some clients might believe diversification is only for wealthy investors. In reality, even small portfolios benefit from diversification through ETFs or balanced funds. Others might also think that diversification limits returns. While concentrated bets can outperform in the short term, they carry greater risk of loss. 

And while diversification aims for sustainable long-term growth, it doesn’t eliminate all risk. What diversification does is it reduces risk. However, it does not remove risk entirely. Remind your clients that every investment will always carry some uncertainty. 

What are the advantages and disadvantages of diversification? 

Despite diversification being one of the most common strategies in investing, it still has both advantages and disadvantages: 

Advantages of diversification 

Let’s first go over some advantages: 

Lower risk of loss 

The biggest advantage of diversification is that it lowers the overall risk of a portfolio. When an investor owns a variety of assets, poor performance in one area can be balanced by stronger performance in another. 

For example, if technology stocks decline, bonds or real estate might provide stability. Having this balance protects wealth and reduces the chance of large sudden losses. 

Smoother returns over time 

Diversification helps even out the ups and downs of investing. Concentrated portfolios often experience sharp swings when a single investment rises or falls dramatically. A diversified portfolio is more stable because it is exposed to more investments. 

This creates smoother returns that are easier for investors to manage, especially when emotions are involved. Stability encourages investors to stay invested rather than react impulsively to market events. 

Access to more opportunities 

By diversifying, investors gain exposure to a wider range of markets, industries, and regions. This increases the chances of benefiting from growth wherever it occurs. For example, the Canadian stock market is heavily concentrated in financial and energy companies. Diversifying into US or international equities allows investors to participate in sectors such as technology or healthcare that are underrepresented in Canada. This broader exposure can enhance long-term growth potential. 

Protection from sector and geographic risk 

Every sector and country faces unique risks. For example, energy stocks are sensitive to oil prices, while technology companies are influenced by innovation cycles and regulation. A portfolio concentrated in one sector or country is vulnerable to these specific risks. 

Diversification protects investors by spreading exposure across different sectors and geographic regions. This reduces the likelihood that a single event will derail the entire portfolio. 

Improved risk-adjusted returns 

Diversification helps improve risk-adjusted returns. This means generating more return for each unit of risk. Even if returns from individual investments are not the highest, the combined result produces steadier growth for less volatility. This efficiency is especially valuable for long-term compounding. 

Psychological comfort 

Investors often feel more secure when their portfolios are diversified. Seeing that not every investment falls at the same time reduces stress. It helps them remain committed to their financial plan instead of making emotional decisions. 

This advantage, while less visible than performance numbers, can keep investors disciplined through market cycles. 

Disadvantages of diversification 

Now, we go over some disadvantages: 

Limited upside potential 

One disadvantage of diversification in investing is that it can limit upside gains. A concentrated portfolio that holds only the best-performing stocks might achieve very high returns. On the other hand, a diversified one might not achieve the highest possible returns during bull markets. 

Diversification spreads money across many investments, so strong performance in one area is diluted by weaker performance elsewhere. 

Overdiversification risk 

Sometimes investors diversify too much. This is called overdiversification. Holding too many investments can make it difficult to track performance or understand the risks involved. At some point additional investments no longer reduce risk but instead add complexity without benefit. 

Overdiversification might also make the portfolio perform like an index fund, reducing the possibility of outperforming the market. 

Higher costs in some cases 

Diversification can lead to higher costs if it is not managed carefully. Investing in multiple mutual funds or alternative products can increase management fees and transaction costs. While some products are low cost, others might charge high fees that reduce net returns. 

You must be careful to make sure that the cost of diversification does not outweigh the benefits. 

Possible tax inefficiency 

Diversified portfolios might generate taxable events across many holdings. Selling one asset to rebalance might trigger capital gains, while foreign dividends might be taxed at higher rates. Remind your clients to take account type and tax treatment into consideration when diversifying. 

Complexity in monitoring and communication 

Diversification in investing adds complexity for both you and your clients. A concentrated portfolio is easier to explain because its performance is tied to a few investments. 

On the contrary, a diversified portfolio can contain dozens of positions across different asset classes. Because of this, it can be harder for clients to understand why results look a certain way. 

Slower recovery after downturns 

Another disadvantage is that diversified portfolios might recover more slowly after market declines. When one sector rebounds substantially, a concentrated investor might regain losses quickly. 

In contrast, a diversified investor might see a slower recovery because other parts of the portfolio lag. This can cause frustration for clients who compare their results to those of concentrated portfolios that bounce back faster. 

Is diversification good for investing? 

Yes, diversification is generally good for investing because it minimizes risk and creates a more stable path to long-term growth. If one part of the portfolio performs poorly, other parts can help offset the losses. This balance makes it easier to handle fluctuations in the market and reduces the impact of unexpected events. 

Even global diversification can be a smart move if done right. Watch this video to see why: 

Diversification can make your clients stay disciplined during market declines. When portfolios are concentrated, losses feel sharper and trigger emotional reactions. Some investors might panic and sell at the wrong time. 

A diversified portfolio cushions those losses, which helps clients remain calm. They see that not every asset class is falling at once. This behavioural benefit might be overlooked but it is one of the most important reasons to diversify. 

Recommending diversification to investors 

Some investors might think that diversification means sacrificing returns. You need to show that the goal is to achieve more consistent returns, not necessarily higher peaks. You can try using historical data and simple examples to explain this clearly. For instance, showing how a balanced portfolio performed compared to a concentrated one during market downturns demonstrates the value of diversification. 

Communication should also emphasize that diversification does not prevent losses entirely. Instead, it reduces the impact of unpredictable events. Help your clients understand that diversification works best as a long-term strategy that can provide them with peace of mind during market changes. 

Setting realistic expectations is the key. Trust grows when your clients see that their portfolios are designed to weather different conditions. 

Learn more about diversification in investing and other related topics when you check out our Practice Management page.