Definition of diversification: How to reduce the risk of your portfolio
Many investors consider diversification to be one of the most important aspects to consider when investing. Essentially, it allows investors to reduce the risk of their portfolios by not relying solely on individual investments. In this article, you will learn exactly what diversification means, what its advantages are and how you can apply it.
In brief:
- Diversification can help you reduce the risk of your portfolio.
- These aspects will help you determine your own risk tolerance so that you can build a balanced portfolio.
- Knowing about the different types of risk helps you to realistically assess potential dangers when investing.
What is diversification?
Diversification in terms of investing means not putting all your money into one company, one asset class or one industry. It could mean investing in companies of all sizes and in different countries, for example. Or investing not just in certain assets, but in stocks, commodities and real estate.
Diversification makes sense above all when investors want to invest their money for the long term. This helps to avoid excessive fluctuations. With this type of investment, the aim is therefore to build up assets as stably as possible over a long period of time, while reducing risk.
The different risks
Before investing your money, you should be aware of the risks involved. You should also get to know yourself to find out how much risk you are willing to take and what risks you are prepared to accept. The overall goal is to avoid losing your entire investment.
In the past, it has repeatedly been shown that risks are often misjudged. One example is the global economic crisis of 2008 and 2009. Many banks misjudged the risks of the American housing market and were forced to file for bankruptcy as a result.
Good to know:
The magic triangle of investing shows the interplay between returns, security and liquidity. It is impossible to achieve all three goals simultaneously with a single investment. It is therefore important to develop a suitable, individual strategy that aims to strike a balance. In other words, the riskier the investment, the higher the potential return.
Basically, two different types of risk can be distinguished when investing: individual risk and general market risk. Market risk can be observed, for example, when the entire German stock market is weak. In this case, not only does the share price of one company fall, but the share prices of most listed companies in Germany also fall.
Companies, for example, bear individual risk. Low competitiveness or poor management can cause companies to run into difficulties. Any financial losses then affect only that company and no others.
Advantages of diversification
No one can predict with certainty whether individual sectors or companies will be able to hold their own in the economy in the long term. As an investor, you still have the opportunity to use diversification to reduce the risk of your own portfolio.
Example:
Diversification often means that an investor owns different asset classes that behave differently in the same situations. For example, demand for government bonds often rises when the stock market falls. With government bonds, investors can lend money to the market and receive interest in return.
The principle of risk diversification was developed by Nobel Prize winners Miller and Modigliani. They researched the relationship between risk and return. Put simply, you can reduce the risk of your portfolio by spreading your capital as widely as possible.
Determine your own risk tolerance
To gain a good overview of your own risk tolerance, there are several aspects you should consider. Here is a selection of some points you should think about beforehand.
- How much capital do you want to invest? Generally speaking, investors with more money can take greater risks, as they are better able to absorb losses.
- If you have any debts, such as a loan, these should also be taken into account. It may be advisable to pay them off first before investing your assets.
- Your current employment status should also be taken into account when assessing your risk tolerance. Permanent employees or civil servants can take greater risks than people who have just started their own business.
- Another important point is the planned duration of the investment. Investors who want to invest their money for the long term can invest a larger portion in stocks or ETFs. The stock market is always subject to significant fluctuations. Long-term investing can help to offset price fluctuations.
- Money already invested, or rather the asset classes chosen for this purpose, also plays a role. Are these mainly safe investments such as life insurance policies, building society savings agreements or fixed-term deposits? Or has money already been invested in high-risk, high-yield assets such as stocks?
Lower the risk of your own portfolio
There are many different approaches to diversifying your portfolio and thereby reducing risk. We will introduce you to a few options.
Practising risk management
There are several mistakes that many investors make time and time again. For example, a relatively large sum is invested in what appears to be a particularly impressive investment. Or the available sum is simply divided equally and invested in different investments.
Every asset class carries different risks and offers different opportunities. The individual risk tolerance of each investor should also not be underestimated. You should therefore ensure that each investment is always proportionate to the total size of your invested assets.
Good to know:
So always keep track of the risks associated with each type of investment and the overall risk of your portfolio in order to achieve a balance that is tailored to your individual risk profile.
Investing in different markets
Many German investors tend to invest only in the German market. For example, they only buy stocks from German companies. Diversification also means covering different markets and not investing in just one country.
Germany could also face an economic crisis. Those who have invested exclusively in German stocks will have to contend with some sharp fluctuations. Those who have invested internationally, on the other hand, will benefit if the American or Asian markets are performing well at the same time.
Utilise different asset classes
Investing your assets in different asset classes can also contribute to diversification. If you invest only in a specific asset class, you are heavily dependent on the performance of individual securities.
Example:
Those who invest most of their money in fixed-term deposits can hardly expect any returns in times of low interest rates. On the other hand, those who invest only in stocks from a particular sector must fear sharp price declines if that sector is not doing well.
Avoid cluster risks
Avoiding cluster risks is also part of sufficient diversification. This may mean, for example, that the stocks you buy should not be too closely related. If you invest in stocks from car manufacturers and, at the same time, in stocks from companies that make software for cars, both prices are likely to plummet if the automotive industry is not doing well.
Attention!
Avoiding cluster risks therefore means looking for potential overlaps in the portfolio and avoiding them. Otherwise, fluctuations cannot be cushioned and balanced out in difficult economic times.
Conclusion: Diversification as a sensible investment strategy
Diversification is a sensible investment strategy for long-term investors who want to minimise their risk. There are various options available for this. For example, you can invest in different asset classes such as call money, commodities, stocks, gold or bonds.
Investments in different countries and sectors offer other opportunities. In addition, cluster risks should generally be avoided. Diversifying your portfolio allows you to better cushion risks and poor performance in difficult economic times.
It is helpful to determine your own risk tolerance. Various factors should be taken into account, such as the size of your assets, debts, money already invested, your current employment status and the planned duration of the investment.
FAQ – Frequently asked questions about diversification Definition
