Diversification: not all eggs in the same basket

In the last article, you learned about the magic triangle and the mutually influencing investment goals of return, availability and security. We now want to delve deeper into the investment topic. In this article, you will find out how you can achieve an optimum risk/return ratio in your investment thanks to intelligent diversification.

Resisting the temptation of stock-picking

Admittedly: It’s not easy to resist the supposedly safe stock tip with rosy profit prospects from a trusted acquaintance. But it’s definitely necessary!

If you invest in a single stock, substantial price losses with no prospect of a sustained recovery are unfortunately an all too realistic scenario.

“The hunt for individual stocks, also known as stock picking, can backfire badly.”

And it is not just exotic stocks that are affected, but also well-known and established Swiss brands, as the Zurich Insurance chart below clearly shows.

Incidentally, the two top dogs in the domestic banking sector, UBS and CS, are showing similarly disastrous share price trends.

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But things could get even worse for you. In the worst-case scenario of “bankruptcy”, you are literally left empty-handed: total loss!

The hunt for individual stocks, also known as stock-picking, can therefore backfire badly. So let’s look around for a better alternative.

Diversification is the solution!

And that brings us to the so-called Modern Portfolio Theory according to Harry Markowitz. He was awarded the Nobel Prize in Economics in 1990 for his groundbreaking doctoral thesis.

Markowitz was the first to provide theoretical proof of the positive effect of diversification on the risk and return of an overall portfolio.

The core of his theory is the distinction between systematic and unsystematic risk.

All securities on the market are subject to systematic risk (i.e. market risks such as interest rate rises, recessions, political instability), so it cannot be diversified and is the risk of the investment itself.

“The company-specific risk can be reduced through diversification.”

The unsystematic risk, on the other hand, is the company-specific risk (e.g. management errors such as in the VW emissions scandal). This risk can be reduced through diversification, i.e. by increasing the number of different securities.

You will achieve the strongest effects if you mix different shares with the lowest possible correlation or with the lowest possible correlation coefficient. The bandwidth ranges from +1 (same development) to 0 (independent development) to -1 (opposite development).

If you want to understand the underlying formula and be reminded of the good old school days, we recommend this explanatory video, which was not produced by us.

Another, less theoretical video, which is unfortunately no longer available, illustrates the positive effect of buying two fictitious shares (umbrella and umbrella company) whose prices move in exactly the opposite direction (i.e. correlation coefficient of -1).

Note: Correlation coefficients within the asset class “equities” of 0.70 to 0.95 are more realistic. Further below in Figure 3 we show correlations between different equity investments and asset classes.

Only efficient portfolios are good portfolios

We recommend aiming for a broadly diversified investment. This means you are not taking any unnecessary risks. By unnecessary risks, we mean company-specific risks (see above) for which you are not compensated by a higher return on the market.

This means that a lack of diversification exposes your portfolio to excessive fluctuations (= volatility as a measure of risk) without giving you a higher return. Efficient portfolios, on the other hand, have an optimal risk/return ratio.

To answer the question of whether your portfolio is efficient, you can use the following rule of thumb.

An equity portfolio consisting of…

• …only one single share is a no-go(see Zurich Insurance above), as it is not diversified at all. There is a (cluster) risk of a total loss.
• …some stocks from Switzerland and various sectors is suboptimal as it is insufficiently diversified. Strong price fluctuations and/or below-average returns are realistic.
• …numerous securities, which are spread globally and across sectors, is recommended as it is broadly diversified. The company-specific or unsystematic risk is (practically) eliminated.

Gerd Kommer, author of the standard work “Souverän Investieren mit Indexfonds und ETFs” (“Investing confidently with index funds and ETFs”) and others, compared the return and risk of three equity portfolios with different degrees of diversification over a 16-year period from 2002 to 2017 in his article published on September 27, 2018 at www.dasinvestment.com using the table below.

The table illustrates that systematic, broad diversification significantly reduces the risk (= standard deviation, highlighted in yellow) in an equity portfolio – without sacrificing returns (= yield, highlighted in yellow).

“The globally and cross-sector diversified equity portfolio combined with other asset classes represents the premier class.”

The premier class of diversification

Finally, the top class consists of combining the globally and cross-sector diversified equity portfolio with other asset classes such as real estate, P2P lending, bonds and/or commodities. This is because different asset classes generally correlate significantly less than investments within the same asset class, as illustrated in the table below.

It is striking that P2P lending and bonds with values close to 0 fluctuate practically independently of equity investments and therefore have a high diversification effect.

While Swiss government or corporate bonds hardly yield any interest in the current low interest rate environment and are therefore not very attractive as an addition to an equity portfolio, we consider P2P lending to be an option worth considering. We will discuss this relatively new and rapidly growing asset class in detail in a separate article.

Note: The calculated values are based on historical data, which is no guarantee for future development.

Conclusion

Stock-picking has more to do with gambling than with serious investing. After all, making big bets on individual stocks and putting all your eggs in the same basket only increases the risk, but not the expected return.

With clever diversification, on the other hand, you can change the risk/return ratio to your advantage. In other words, you take a lower risk while the return remains the same.

You will achieve the greatest diversification effects if you take different asset classes into account when investing.

“Thanks to diversification, you get a free lunch”.

In stock market jargon, this is referred to as a “free lunch”, which is offered to you thanks to diversification. Incidentally, there are no other “free lunches” when it comes to investing. Returns and risk are inseparable siblings. So take advantage of this wonderful diversification effect!

In the next article, we will look at the topic of asset allocation and how you can diversify your assets easily and in line with your individual risk profile using a global portfolio.

You can get a complete overview of the topic of “Investing” here: Learning to invest – in eight lessons.

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Disclaimer

Disclaimer: Investing involves risks of loss. You must decide for yourself whether you want to bear these risks or not.

Errors excepted: We have written this article to the best of our knowledge and belief. Our aim is to provide you as a private investor with the most objective and meaningful financial information possible. However, should we have made any errors, forgotten important aspects and/or no longer have up-to-date information, we would be grateful if you could let us know.