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Diversifying Your Portfolio: Why It's Important and How to Do It

  • Rush
    Rush Vermögenstracker e.U.

What is portfolio diversification?

When a portfolio is diversified, it includes different asset classes, such as equities, bonds, real estate and commodities. It can also be differentiated into different economic sectors, geographic regions and asset types. This strategy makes it possible to achieve potential returns from different sources and to reduce the impact of negative events affecting a particular asset or sector. Through diversification, we pursue the goal of reducing the concentration risk associated with investing in a single asset class. It is based on the principle that different asset classes have unique risk and return characteristics and their performance may vary under different market conditions. In a nutshell, if you put all your eggs in one basket and you lose, it is truly annoying and it could have been avoided in the best case scenario. 

Spreading your funds across multiple asset classes helps reduce the impact of poor performance of any one investment on your overall portfolio. Harry Markowitz, Nobel Prize-winning economist, highlighted the importance of diversification in his modern portfolio theory. This theory states that investors can achieve the highest possible return for a given level of risk or the lowest possible risk for a given level of return by combining assets with different risk and return characteristics.

Diversification aims to balance risk and return. While it cannot completely prevent some risk, it can help manage and mitigate it.­­­

The advantages of diversification

One of the main benefits of portfolio diversification is risk reduction. In a comprehensive study by Brinson, Singer, and Beebower (Ibbotson, Roger G., and Paul D. Kaplan. "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" Financial Analysts Journal 56, no. 1 (2000): 26-33. http://www.jstor.org/stable/4480220.) found that asset allocation decisions, including diversification, are responsible for more than 90% of the variation in portfolio returns.

In addition, diversification can lead to more consistent and stable portfolio performance. Diversification can reduce the volatility of a portfolio, which ultimately enhances the investor's investment experience and confidence in their investment strategy.

In addition, diversification can help investors avoid behavioral biases. Emotional decisions and the pursuit of short-term trends can lead to poor investment results. Diversification makes it possible to create a disciplined and structured investment approach that reduces the temptation to make impulsive decisions based on market fluctuations.

Portfolio diversification strategies

Asset allocation is a key strategy for diversification. It involves determining an appropriate mix of asset classes based on one's risk tolerance, time horizon, and financial goals.

  1. Geographic diversification is another effective strategy. By investing in different regions or countries, one can reduce the risk associated with local economic events. A study by MSCI found that including international investments in a portfolio can increase diversification benefits and potentially reduce risk. International markets often have different economic cycles and market dynamics, providing opportunities for diversification.
  2. Sector diversification involves investing in different sectors or industries. Different sectors have different risk and return characteristics and may perform differently under different economic conditions. For example, sectors such as technology or consumer cyclicals may outperform during economic upturns, while defensive sectors such as utilities or consumer staples may provide stability during economic downturns. By diversifying across sectors, investors can reduce the concentration risk associated with a particular industry.
  3. Another diversification strategy is time diversification. This approach involves investing in assets with different time horizons. For example, one can invest a part of the portfolio in long-term assets such as stocks or real estate, which promise higher returns over a longer period of time. At the same time, one can also consider short-term investments such as bonds or money market funds, which offer short-term stability and liquidity.
  4. Alternative investments can also play a role in diversification. Just a few sentences on this, we will go into a bit more detail here in an upcoming article. These investments include assets such as private equity, venture capital, hedge funds and commodities. Alternative assets often have a low correlation with traditional asset classes and thus offer the opportunity to further diversify one's portfolio.

Implementation of diversification

Implementing diversification requires careful planning and ongoing monitoring of one's portfolio. Of course, it takes a lot of practice to really have a good sense and the right approaches here. And of course, it borders on mockery to say that it's easy to learn in just a few steps. But as with everything, it's said that "practice makes perfect" and "everyone started small". So you shouldn't get discouraged. And with a few small mnemonic aids you will at least have an easier start:

  1. Define your investment goals: Before diversifying your portfolio, clearly define your investment goals, risk tolerance and time horizon.
  2. If available: Evaluate your current portfolio and determine the level of diversification already in place. Determine in which areas there are concentrations or overlaps that may need to be adjusted.
  3. Decide what allocation is right for you: based on your investment goals and risk tolerance, determine the appropriate allocation of assets among different asset classes such as stocks, bonds, real estate, and alternative investments.
  4. Select investments: Once you have decided on a allocation, it is time to carefully select investments within each asset class.
  5. Monitor and rebalance: This is clearly where you need to stay tuned. Just because you've read in once and have the big picture, doesn't mean you're done. Monitor your portfolio regularly to make sure it's in line with your desired asset allocation. Over time, certain investments may perform better or worse, resulting in deviations from the original allocation. So adjust the portfolio periodically to bring it back in line with your target allocation.
  6. Stay informed: Keep up to date with market trends, economic conditions and industry developments.

Of course, we realize that none of this can be done overnight and may take a lot of time. But if you keep at it, you will understand your own finances and will benefit from this understanding in the long run. And unfortunately it still remains: Despite the best intention in diversification, neither profits can be guaranteed, nor losses excluded. Markets simply continue to be influenced by various factors, and investment returns can fluctuate.

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