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What Is Portfolio Diversification and Which Types of Diversification Exist?
Portfolio diversification means to create a good mix of investments within a portfolio which are ideally negatively correlated. Or simply said: Don't put all eggs into the same basket. In the world of investing, you want to be diversified across different asset classes such as equity, bonds, commodities, real estate, cash, art, private equity of venture capital, and some might also consider cryptocurrencies.
Each asset class can be further diversified by owning companies from different regions or industries (e.g., oil & gas, semiconductors). So, there is diversification due to different asset classes in a portfolio as well as within an asset class (e.g., shares from different regions).
Some investors choose to go the opposite direction, for example, by heavily investing only into shares of a single company. They are taking high risks by placing concentrated bets on very few assets which could lead to irrecoverable losses as some examples will show further below.
The Importance of Portfolio Diversification
But why should every investor consider portfolio diversification? It is simple: If one company goes bankrupt or one asset class underperforms, then others will compensate for the loss. Also, one single company might loose 50% and more of its value and never recover if its business model was disrupted - while markets always recovered over time.
So, owning only one type of asset is riskier than diversifying into different ones. Portfolio diversification can lead to lower risks and higher return over the long run. The benefits of diversification were proven by Harry Markowitz, the US Nobel price winner for Economic Sciences in 1990, in his modern portfolio theory.
Let's speak simple math: A wise investor wants to invest 20,000 EUR, representing 100% of his total portfolio. Instead of owning only stocks of one single company, the decision is to allocate 1,000 EUR to each of the 20 different companies selected from various sectors. That represents only 5% of the overall portfolio per company. If the share price of one company drops by 50% in an extreme event that would lead to a total portfolio loss of only 2.5% (= 500 EUR).
Why Regional Portfolio Diversification Is Important - Recent Examples
Just recently it became so obvious how important regional portfolio diversification for investors is. For example, with introduction of economic sanctions against Russia due to its war against Ukraine, investors outside Russia lost access to Russian companies owned via shares and also investment funds. As compensation, special dividends were paid to foreign shareholders of Russian companies when they were excluded from market indices. Still, the loss was limited since Russian companies accounted for only 4% of the MSCI Emerging Market index beginning of 2022. The picture looked different for investors holding equity ETFs with strong focus on Eastern Europe. Here, the index weighting of Russian companies was significantly higher.
Another example with regards to the importance of regional portfolio diversification is the regional conflict between China and Taiwan. If China heats up the regional conflict, the entire semiconductor industry would be heavily impacted by that, as Taiwan is one of the main producers. Without semiconductors the world economy would suffer and so would companies' earnings. Needless to say how markets would react especially in that region (Taiwan, China, Japan, South Korea).
Development of Global Sales Volume of Top Semiconductor Companies 2007-2021
Why Asset Diversification Across Different Sectors And Industries Is Important
Another example supporting portfolio diversification is the performance of the energy sector in 2022. For years, investors were avoiding energy companies since other areas like the tech sector were offering significantly higher growth and paid attention to ESG criteria which filtered such companies from ESG compliant investment products. Same is valid for companies from the defence and tobacco industries, also being excluded from indices due to ESG criteria. As a consequence, investment products applying ESG filter criteria were underperforming broader indices including companies from such industries.
What Is the Best Level of Diversification?
The "best" level of diversification is a subjective term and will vary depending on an individual's specific financial situation, investment goals, and risk tolerance. However, in general, a diversified investment portfolio is one that includes a mix of different asset classes, such as stocks, bonds, real estate, and commodities, with the goal of spreading risk and reducing the impact of any one investment's performance on the overall portfolio.
There are different recommendations for the best level of diversification in a portfolio. Some recommend to hold shares of 10 different companies from different sectors in order to benefit from lower volatility and a security buffer if one or two companies underperform. Others rather see 25-30 as the right level of diversification. In a portfolio with 25-30 different investments, regional diversification could be applied, too. More diversification could lead to lowering the portfolio's return due to high transaction costs. But identifying those 25-30 best companies for your basket is extremely challenging. Based on which selection criteria would you find the best candidates? Do you have the time to follow the development and news of all 25-30 companies? When to buy - when to sell?
However, it's important to remember that diversification alone is not a guarantee of profits or protection against losses, and that investment performance will depend on the specific investments included in the portfolio and market conditions over time. Additionally, it's crucial to regularly review and rebalance a diversified portfolio to ensure that it continues to align with the investor's financial goals and risk tolerance.
ETFs as Best Low-Cost Option for Portfolio Diversification
But what if you could simply buy a basket of companies representing a broad market index such as the S&P 500, MSCI World or Stoxx 600 against super low fees? Exchange-traded funds, also called ETFs, are one low-cost option. They have opened the door to global portfolio diversification also for private investors with smaller budgets at very low costs (<0.4% p.a.). ETFs are available for different asset classes, like equity, fixed income (bond ETF), real estate (REIT) and even broad commodity indices (ETC).
With an investment of only 50 EUR you could buy the whole world and simply hold it for a very long period of time. That's called buy-and-hold strategy and has proven to be superior to active stock picking in the long run. With a simple buy-and-hold strategy some investors managed to double their money invested in less than 10 years.
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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