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A Portfolio Should Distribute The Risk As Well As Possible

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A Portfolio Should Distribute The Risk As Well As Possible. Therefore, the logical goal of any financial investment is to maximize the possible return with the lowest possible risk. In addition, a flexible approach that enables prompt liquidity, if necessary, is desirable. This can be achieved, for example, by betting on different assets that are not necessarily directly related to one another.

Example: If someone bought shares in nuclear power companies ten years ago, they could earn good money with them. However, at the time of the nuclear phase-out, the losses hit him/her in full, as all stocks had similar requirements. An intelligent diversification of the risk on companies’ values ​​that rely on green electricity would partially offset or even offset these losses.

A Portfolio Should Distribute The Risk As Well As Possible

Of course, it doesn’t always have to be in the same industry. Effects in one industry can show up in completely different ways in other industries and vice versa.

This can also be applied to entire markets. For example, if the stock exchange in Asia is weak, that doesn’t necessarily have to be bad for Europe’s stock exchange. This interdependence of values ​​is known as correlation. A low correlation is advantageous for optimal diversification.

Diversification Subspecies

Generally, experts distinguish between four types of diversification. Each is based on a different basis:

  • -Diversification in terms of asset classes
  • -Diversification in terms of investment regions
  • -Diversification in terms of investment sectors
  • -Diversification in terms of the investment period

Diversification in terms of asset classes

The point here is not to invest the entire investment amount in a single asset class. Shares may be particularly promising. In history, however, there have been numerous crashes in which shareholders have lost a lot of money because the stock market has collapsed across the board.

Investors who only invested part of their money in stocks and the rest in bonds, fixed-term deposits, and real estate could better cope with such a slump.

Diversification in terms of investment regions

The situation is similar with the second form of diversification. Make sure your money is not overly concentrated in one region. For example, suppose you only have shares in US companies, investment funds with a focus on the USA and bonds from US companies in your portfolio. In that case, you shouldn’t be surprised that you suffer heavy losses when the US economy weakens.

Conversely, if he had invested money in Europe and Asia, he could probably offset the losses with gains in other areas. It is even more risky to concentrate on smaller and less developed countries and regions whose economic development is often characterized by high volatility.

Diversification in terms of investment sectors

The third point is best illustrated with an example. The solar industry was considered a boom at the beginning of the millennium.

However, anyone who unilaterally bought shares, bonds, and investment funds in this area in their trust and still holds them today is likely to be sitting on high losses because they have not diversified their money sufficiently and invested them in other industries.

Diversification in terms of the investment period

The last form of diversification relates primarily to investments with a fixed term – such as time deposits. Here, investors should make sure that their investments do not all mature at the same time. That can make reinvestment more difficult – for example, in times of low-interest rates – as well as strain liquidity.

Exemplary distribution of risk through diversification:

  1. European government bonds
  2. Corporate bonds
  3. Global stock markets
  4. Raw materials
  5. Foreign currency

A portfolio that includes investments in the sample values ​​above would be a broad investment that includes both safe and potentially very profitable components.

Government bonds are generally considered very safe, but they bring comparatively little income and have lost importance in the wake of the debt crisis in some countries.

However, the sovereign debt crisis has given a boost to corporate bonds, which promise investors a better return with a slightly higher risk and, at the same time, serve to raise capital for companies.

Broad diversification through investments in the global equity markets’ values decouples the risk from individual markets and offers opportunities for income in other areas.

Last but not least, raw materials are always a good indicator of the economy. Gold and oil in particular, were sought-after objects for speculation in the past, but they pose a relatively high risk due to their high dependence on economic and political developments. However, their short-term returns often overshadow everything else.

According to this pattern, investors who diversify themselves against many risks and at the same time benefit in many conceivable scenarios. The profits and losses must be balanced, but ideally, the losses are compensated by diversification and that there is still a return.

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