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Private investors as well as professional investors such as asset managers, hedge funds or sovereign wealth funds pursue different objectives when investing money.
This is also accompanied by a difference in the Riskwhich the aforementioned investors enter into. However, an important building block in the portfolio composition should be the same: Diversification. But what does diversification mean anyway?
An investment principle, which is often used, but rarely explained. We would like to change that. In this blog post, we explain diversification and show why your portfolio should also follow this investment principle.
Basically, diversification is explained simply, namely with the word risk diversification. This means spreading the investment risk by investing in different financial products. Sounds quite simple, doesn't it? However, there is a little more to it and therefore we will now look a little more in depth, how diversification is explained.
The magic investment triangle
When searching for the answer to the question what does diversification mean, you quickly come across three criteria of investing. These are also called the magic investment triangle: Profitability, liquidity (or availability) and security (or risk). Why is that? The goal of diversification is to put a portfolio on different legs, especially to spread the security/risk component sufficiently. An investment in a risky form of investment can always bring you more return, but can also lead to a total loss. Therefore, it is even more important not to put all your eggs in one basket, but to include different forms of investment in your investment strategy.
When investing in one or more forms of investment, it is always important to keep in mind different forms of risk. The industry in which a Public limited company doing its business can be no matter how good if the company's management is not doing a good job, and conversely, an outstanding company in a market with no future is unfortunately not the best investment idea either. Later we will discuss, how to choose stocks and ETFs for diversification can.
The situation is similar for other forms of investment such as Government bonds (Keyword Greek government bonds on the financial crisis).
Knowing what diversification means in one's portfolio, therefore, also means assessing individual market risks (= e.g. bad management of the company) and general market risks (= e.g. an industry is no longer promising). Thus, you should always consciously include or exclude different risks in your investment decisions when compiling your portfolio.
We have now explained the term diversification, but now we want to look at which investment forms we want to put into our portfolio and how we can achieve risk diversification. The following investment forms could be interesting for your asset allocation and thus represent diversification examples:
Now that we've explained diversification, it's time to figure out which investments belong in your portfolio. Wildly buying stocks and ETFs from different countries can also backfire.
Should you If you do not want to analyse every single share from a sector or country, a one-off investment or regular saving in sector or country ETFs is recommended. ETFs diversify due to their nature as an investment product in indices from different countries or industries and offer you an excellent solution for diversification in your portfolio.
In addition to investing directly in ETFs or passively saving in an ETF savings plan, a Robo-advisors like Selma can be very useful in diversifying your portfolio. Based on your personal desired investment style and your personal financial situation, the Robo-Advisor and invests your money in ETFs and other asset classes tailored to your risk profile.
Risk diversification in your Portfolio is an essential investment strategy and a principle you should follow. To support this diversification strategy, the assistance of a Robo-Advisors and the use of ETFs is an absolutely recommendable way to reduce extreme fluctuations in your portfolio. We have had very good experiences with Robo-Adivisorn, so feel free to take a look at our financial tips.
Hopefully you now know the answer to what does diversification mean and how do you implement it. You have more questions about risk diversification? Then you should also read our article on Risk-return ratio read!
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2 Responses
Good explanation. But what is still missing is a rough recommendation of diversification. I am a big fan of stocks, but still is not more 75% in it for my investments. The rest is invested in tangibles and precious metals that you can liquidate even in bad stock market times if you need money.
Hi Lars, thanks for your good feedback!
Depending on factors such as time horizon or risk appetite, diversification can of course look very different in each portfolio. Would a few case studies be interesting for you? Then maybe this would be a complementary article 🙂