When it comes to investing, few concepts matter more than diversification. While most investors have a general understanding of what diversification entails, executing the strategy effectively is much more nuanced than appears at the surface. This is especially true in today’s investment climate where factors such as soaring inflation, slowing economic growth and aggressive shifts in central bank policy have undermined traditional diversification methods. So, while the core tenants of diversification remain the same, the strategies for achieving it are shifting.
What Is Diversification?
Diversification is an investment technique that attempts to reduce risk by allocating capital across various asset types and categories. The strategy aims to minimize losses by investing in different asset classes that may react differently to economic events or scenarios. The rationale is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security. For example, an investor may allocate a certain percentage of their portfolio to stocks, which grow in good times, and a certain percentage to bonds, which can help them preserve capital during challenging times. The general idea is not to be overexposed to one asset class or sector and not to put all your eggs in one basket.
The Core Concepts of Diversification
The benefits of diversification are rooted in the concepts of correlation and variance. Correlation is a statistical measure that evaluates the degree to which two assets move in relation to one another. Highly correlated assets tend to move in the same direction whereas non-correlated assets move independently of one another. Variance measures the historical range in which a particular asset fluctuates around its expected returns. For assets with a high variance, such as stocks, returns tend to vary wildly above or below their average annual return. High variance is not necessarily a bad thing – after all, it could lead to higher returns in good years. However, from the perspective of diversification, assets with high variance are only beneficial if they are accompanied by another uncorrelated asset within the same portfolio.
By applying these core concepts, investment managers for decades have advocated a balanced portfolio that consists of 60% stocks and 40% bonds. This diversification method has benefited investors by reducing volatility, minimizing portfolio losses and enabling equal or higher returns for less risk than undiversified portfolios. Behavioural finance also tells us that diversification benefits investors by offering peace of mind knowing that their investments aren’t overly concentrated in one sector, industry or asset type.
How to Diversify Your Portfolio in Today’s Climate
The traditional 60/40 asset allocation described above benefited investors for decades because the correlation between stocks and bonds had been consistently negative – meaning that investors could rely on their bond investments for protection when stocks declined. That consistently negative correlation is showing signs of breaking down, with the 60/40 portfolio in 2022 on track for perhaps its worst year ever. Soaring inflation, major shifts in monetary policy and slowing economic growth have forced investors to look for a replacement to traditional asset allocation models. The rise of alternative investments has provided investors with more reason to diversify more broadly than what the traditional 60/40 model entails.
Mortgages are one of the fastest growing segments within alternative investments, providing investors with steady cash flow, exposure to real estate without the risk of homeownership and broader diversification benefits beyond just stocks and bonds. Mortgage investments also satisfy one of the core tenants of diversification: low correlation with public markets. As demand for non-bank mortgages continues to grow in Canada, investors will have more opportunities to fill a crucial void in Canada’s mortgage market.
To learn more about how you can diversify your portfolio with mortgage investments, contact CMI today. Since inception, CMI has originated more than $1 billion in mortgages across the country, providing our investors with innovative mortgage investment options with highly competitive returns.