Diversification: why is it important?

Any investor knows that putting all their assets in one basket is just not a good idea. If you are looking to invest in securities successfully, you should spread your assets between different investment tools, industries, currencies, countries and regions of the world. Diversification is the keyword here.

Diversification explained in simple terms

The term diversification comes from economics and means that options are increased and risks are reduced. In the financial sector, it refers to spreading funds across different markets, sectors, currency areas and securities. This reduces your chances of backing the wrong horse. Good diversification also makes it possible to offset negative performance in individual securities with other securities. 

The “magic triangle” of asset investment

Investing often involves a combination of three main factors: security, availability and return. These factors vary depending on the investment category and cannot all be optimally achieved simultaneously.

This is known as the “magic triangle” of asset investment:

• Those who favour security, for example, choose a low-risk investment, but usually accept a lower return.
• Meanwhile, those who want a liquid and easily tradeable investment can invest in shares but also have to accept a higher risk.

This is where diversification comes into play. The more diverse the portfolio, the better the characteristics of the individual investments will balance each other out. With broad diversification and a combination of different investments, investors can combine all three characteristics within their portfolio.

But just why is diversification so important?

A diversified portfolio will help to spread risk, and ultimately minimize it altogether. Financial theory distinguishes between systematic risks and unsystematic risks. Systematic risks are essentially unavoidable.

Any investor must hazard the risk of things like political events or natural disasters having a negative impact on the stock market. This is why investors get premiums, after all. Specifically, they get what is known as a risk premium.

In simple terms, risk premiums are a sort of reward investors receive for picking a riskier investment over a safer investment. It is not paid to investors directly in cash, but factored into the investment’s return. The greater the risk, the higher the potential return.

Unsystematic risks (e.g. the risk of a loss because of a company going out of business), on the other hand, can be significantly reduced by diversifying. This is precisely why you should not solely invest in individual companies or industries so that you can offset potential losses with other investments. The smaller the correlation between the investment categories you choose, in other words the more they differ, the greater the diversification effect.

Opportunities for diversification

As mentioned previously, there are various ways to diversify a portfolio. 

Diversification by investment category

Investors have various investment categories to choose from, each with their own characteristics and different risk-return profiles. The most important of these include equities, bonds, commodities, precious metals, real estate and alternative investment strategies. The money invested is distributed based on your personal risk appetite.

You can read more about this topic in our blog post “Asset allocation: investing your assets in a structured way”.

Geographical diversification

Most investors have the strongest connection to their home country. They know the companies there and are aware of economic and political developments. However, for reasons of risk diversification, it makes sense to invest some of the money in other countries and different currencies.

Sectors

Investors can also diversify by investing in different industries and sectors. It is important to choose sectors that are as unrelated as possible. This approach minimizes the risk of investors’ investments being adversely impacted by identical market developments.

Diversification by investment horizon

Another option for diversification is to take the investment horizon into account. Investments often have different terms. You should take advantage of this for diversification. After all, if multiple investments mature simultaneously at an unfavourable time, the potential for loss increases. Long-term investments can often offer good potential returns, but that also means the funds remain tied up for a long time. Investors who focus only on long-term investments should take care not to jeopardise their solvency during this time.

How diversification works – example portfolios

The following example shows exactly how diversification works, which is no guarantee of the actual or future performance of an equity portfolio. Let’s assume that in 1999 we invest CHF 10,000 each in three different portfolios In the context of a fund or securities custody account, a portfolio refers to the composition of the types of investment it contains (e.g. shares, bonds, etc.). with an investment horizon of 25 years. The return The overall success of an investment compared to the capital that you as an investor have invested in it. corresponds to the annual return in percent. We calculate the risk by working out how much higher or lower our returns were compared with the average figure.

Let’s compare the three portfolios

Swiss shares

We only invest in Swiss equities according to the Swiss Performance Index (SPI). This gives us an average return of 4.90 percent per year, with a risk of 13.10 percent. 

Emerging markets

We only invest in shares from emerging markets. This gives us a higher annual return (5.80 percent), but the risk is considerably greater (20.40 percent).

Mix of shares

We invest 5,000 francs in emerging markets and 5,000 francs in Swiss shares. This will give us a slightly higher return than if we were just investing in emerging markets, while the risk we run is significantly reduced (16.30 percent).

So far, so good. By diversifying, we have already managed to optimize our share portfolio. What would happen, though, if we went for another investment category? Let’s take a closer look at bonds. 

• Global bonds: we only invest in various bonds. We would usually be taking a very low risk of 3.30 percent, although this would give us our lowest return so far, with an average of 1.80 per year. 
• 60 percent mix of shares, 40 percent bonds: we combine our successful mix of shares with our secure bonds. This would produce a relatively high return (thanks to the shares) at a significantly lower risk (thanks to the bonds). 

Diversification with a small amount of assets

If the investment amount is relatively low, it is almost impossible to purchase enough different individual securities or assets and to ensure diversification in the portfolio. It can also require a lot of time and high fees to modify the weighting of the assets in line with market developments.

Funds and ETFs

Investing in funds and ETFs (exchange-traded funds) can be a good option rather than individual shares.

A fund is a “pot” into which investors put money. This is invested by the fund management based on certain criteria in various securities, for example, shares or bonds. This means good diversification can be achieved even with a low level of investment.

An ETF (exchange traded fund) is usually managed passively. This means it tracks the performance of a pre-defined index, such as the SMI. They are often cheaper than actively managed funds as they track an index. They are also ideal for creating a well-diversified long-term portfolio with a low investment.

The success of an investment in relation to the capital you as an investor have invested in it depends entirely on the preferences of the investor. For example, asset allocation funds are offered. There are also funds which invest exclusively in certain areas, such as technology. Alternative investments such as real estate, gold or cryptocurrencies are another option for greater diversification.

Smart diversification is half the battle

The same applies to risk-taking and risk-averse investors: diversify! Even if you generally like to take risks, a degree of smart diversification will help you get more from your investments, just as our example illustrates. You can find more smart tips about investing in the article: “Learn about investing with the best tips from famous investors”.