How to diversify a Portfolio
Updated: May 6, 2020
This is Finance 102: Learn how to mitigate risks by investing in a diversified portfolio like investment funds, index funds and ETFs
What is portfolio diversification?
Portfolio diversification can be defined as a strategy to spread your investment into different assets and asset classes to mitigate the risks of losing money. By investing not only in one but into a variety of assets you’re not dependent on the development of one particular asset.
This idea is based on sound science, namely Harry Markowitz’s Modern Portfolio Theory.
He shows that a higher return can only be achieved by higher risk taking. If you want no risk at all (Risk-Free Asset) you can keep the money on your savings account but only gain few (or zero) interest. When you’re venturesome you can invest in individual growth stocks and gain high return. However, the best balance between risk and return can be achieved by investing in the whole market (Market Portfolio).
Mathematically this can be explained by a combination of assets that have a low correlation to each other which mitigates risks. Example: You invest in company that produces sunglasses and in another company that produces umbrellas. If we have many rainy days this season people buy umbrellas but no sunglasses. The stock of the umbrella company goes up, the stock of the sunglasses company goes down. And vice versa if we have many sunny days in the season.With this strategy you profit from the general market growth of both industries but mitigate risks that one of the company is not as successful as expected.
Another clue: If you understand the mathematical formula of portfolio diversification you’ll see that there is in average not a loss of return when investing in two different industries. Instead your return stays high but you’re risk is mitigated simply by the fact that you applied a diversification strategy.
How to diversify a Portfolio: Why is Portfolio Diversification Important?
Portfolio diversification is important for risk averse investors who do not just want to go all in with their money by investing only in one stock. Instead you’re looking for a long-term gain of your assets by mitigating unnecessary risks. For example:
Let’s say you invest in 10 different stocks. One of the companies suddenly gets bankrupt. If you have invested 100 % of your money only in this company, you would have lost everything. However, in a portfolio the other 9 companies still go well, so that they can compensate the loss of the bankrupt company. Furthermore portfolio diversification lowers the overall volatility of your assets. Since the stock market has ups and downs, a widely spread portfolio will usually not be as much affected as an individual stock.
How to diversify your investment portfolio?
There are two ways to diversify your investment portfolio:
How to diversify a Portfolio: Create your own Portfolio
That means you need some research to find the assets you want to combine together. In case of stocks look for good companies in different countries, industries and sizes. Don’t go only for stocks in your country because this country can fall back to the others. Same can happen if you invest only in one industry, e.g. automotive industry. Who knows if this one industry will still exist in 10 years? Rule of thumb: Invest in at least 20 different stocks. Scientist Bruno Solnic illustrated the diversification effect by a graph that shows a domestic and an international strategy. Altogether, you should only apply this idea as an advanced investor since it needs some time and knowhow to create a portfolio on your own.
How to diversify a Portfolio: Buy Index Funds
If you want to lean back, you can also buy an already prepared portfolio by investing into a fund. Either you choose a mutual fund, that is administered by a fund manager or you choose a passive index fund like an ETF. I’m not a big fan of the first concept - investing into an actively managed mutual fund because they have high commissions and management fees that they altogether cannot compensate by a better performance. On the other hand, ETFs have very low costs and perform pretty good for the fact that they just replicate a market index. The most famous ETF is the MSCI World which replicates 1.600 companies in 23 industrial countries.This diversification should be more than enough and it performed in average about 8 % per years.