How To Properly Diversify Investments. If you want to secure investment as optimally as possible, it is crucial to recognize the dangers of individual securities and to achieve maximum risk diversification. In this way, losses can be compensated and cushioned. But what exactly does risk diversification mean and what should one do to achieve it sufficient?
What is risk diversification?
Risk spreading or diversification is usually about minimizing the overall risk of a portfolio (portfolio risk) by, for example, combining securities from companies from different industries and countries. This divides the overall risk into other individual risks, and the diversification means that less risky ones balance out riskier stocks. The diversification of risk therefore plays an essential role in the composition of a balanced portfolio.
How much value an investor attaches to diversification depends on their investment strategy. If he prefers security above all, diversification or risk diversification is incredibly essential. If, on the other hand, a risk-conscious, return-oriented investment strategy is pursued, the diversification of the securities may be of secondary importance or less necessary.
The stock market wisdom for the risk strategy: “Don’t put all your eggs in one basket!”
Risk Diversification On The Stock Exchange
When putting together an equity and bond portfolio, the question of the degree of diversification inevitably arises. There are yield-oriented investment strategies such as the dividend strategy, which make a high degree of diversification difficult. However, suppose you want to invest in a security-oriented and low-risk manner. In that case, it is vital to design an equity portfolio in such a way that it has a high degree of diversification.
How do I put together a diversified equity portfolio?
A diversified equity portfolio should be based on the heavyweights of the stock market (called blue chips or large caps). This means companies with a high market capitalization that are considered to be less risky.
Small caps, on the other hand, have a low market capitalization and are therefore significantly riskier. Even with a risk-conscious investment strategy, no more than 15% to 20% of the equity portfolio should consist of small-cap stocks.
What else is there to consider?
However, it is not enough to be based on market capitalization when putting together a stock portfolio. Because in addition to stock-specific risks, other dangers such as market risk should be considered. This means risks that arise as a result of the development of the securities market and to which all or many stocks in the relevant sector are subject. Besides, there is a currency risk when investing in foreign currencies, which arises from currency fluctuations.
How does successful risk diversification work?
To spread the risk successfully, one should distribute the investment sum to individual stocks in such a way that the different dangers of the individual securities are balanced. Those who master this balancing act will receive a balanced portfolio of stocks that is theoretically referred to as “efficient”.
What difficulties are there in putting together diversified portfolios?
Putting together a stock portfolio is a complicated and complex process. First of all, the selection of individual stocks is associated with a high selection effort. To create a balanced equity portfolio, not only do the individual stores have to be researched thoroughly, their interplay has to be understood and adapted.
In this context (existing) correlation matrices, which statistically represent the interrelationships (correlations) between the stock values, can be helpful. According to Markowitz, investors should combine stocks with a negative correlation to achieve the most significant risk diversification possible.
Another difficulty is that many investors ignore the fees involved in buying and selling stocks. But the more often a buying or selling process is carried out, the more often broker or bank has to be paid for it, and the more has to be deducted from the net return.
Risk Diversification Across Different Asset Classes
To achieve the best possible risk diversification, it is advisable to focus on other types of asset classes in addition to stocks. If there is a stock market crash, even a remarkably diversified equity portfolio can lose massive amounts of value.
In addition to alternative investments, investments can be made intangible assets such as real estate outside of the stock exchange. Since a lot of capital is always required to buy a property, it is difficult to achieve a proper risk diversification here. To achieve a well-diversified real estate investment with relatively little capital, real estate investments are a sensible solution.