Guide: Optimising your portfolio with diversification

Broad portfolio diversification is considered a key principle for successful long-term investment. The following article explains the significance of the term, what exactly it means, what types of diversification there are and how investors can easily implement a diversification strategy.

Inhalt

1. Definition: the principle of diversification
2. Objectives of diversification
3. Different types of diversification
4. Different asset classes
5. Easy diversification with ETFs
6. Conclusion
7. Diversified investing with relevate

Definition: the principle of diversification

“Don’t put all your eggs in one basket” is one of the best-known stock market sayings. It means that investors should divide or spread their investments between different assets – a process known as diversification. One definition of diversification can be found in the financial dictionary of the Handelszeitung newspaper:

[…] In the financial world, diversification refers to the spreading of risks in a portfolio by using heterogeneous assets and investment forms while at the same time generating the highest possible return.

According to this definition, diversification has a further dimension in addition to dividing one’s investments up between different asset classes such as equities, various types of fixed-income securities, precious metals and commodities, cash, currencies, cryptocurrencies and real estate – the term also refers to diversification within an asset class. Investors should focus not just on one stock, but on different stocks from different industries, countries and regions.

The opposite of diversification is concentration. In this case, the portfolio consists of one or very few securities from just one asset class. However, this approach may give rise to what are known as “cluster risks”. This refers to the accumulation of default or loss risks due to the overweighting of only one asset class, industry, country or individual security.

Objectives of diversification

Risk reduction

Everyone who invests money on the capital market runs the risk that the value of their investments might fall. As a result, investors are always keen to find ways to reduce the likelihood of losses. One way to do so is to spread investments across different asset classes and securities. The reason why it is better to diversify risk in this way is that not all asset classes and securities perform in exactly the same way.

Here’s an example: The Swiss equity index SMI fell slightly by 0.3% between the beginning of 2023 and the end of September 2023, while the Swiss Bond Index, which measures the performance of Swiss government bonds, gained 3.67% over the same period and gold was up around 3.5% in Swiss francs. However, the individual asset classes aren’t the only things that perform differently – different equity markets also exhibit different trends. Germany’s leading index, the DAX, climbed by 8.65% in the same period, while the leading US index, the S&P 500, was up by more than 12% in dollar terms.

In technical jargon, it is said that the individual asset classes, markets and individual securities do not fully correlate with one another, i.e. they do not follow exactly the same course. Therefore, investors who diversify are not dependent on the performance of an individual security or asset class, but can compensate for losses in one area with profits in other areas over the long term. In this way, broad diversification can help to reduce portfolio risks. Or to put it another way, the risk-return ratio of the portfolio can be improved with good diversification.

Home bias and its dangers

The phenomenon of “home bias” can be found all over the world. This term refers to people’s tendency to invest more in their domestic stock markets as they believe they know companies from their own country better and therefore trust them more. However, such an approach demonstrably increases risks in the portfolio.

Many national equity markets exhibit cluster risks in certain sectors or in individual securities. For example, pharmaceutical and chemical stocks make up around 40% of Switzerland’s leading index, the SMI, with Roche and Novartis alone accounting for almost 30%. At roughly 23%, Nestlé is another dominant share in the SMI. In European equity indices, on the other hand, the financial sector is very strongly represented, while the technology sector is significantly underweight compared to the US.

As explained above, a narrow regional focus in the portfolio also means that investors will miss out on return opportunities in other markets. For this reason, it is important to overcome home bias and diversify globally.

Exploiting additional revenue opportunities

Another objective of diversification can be to improve the long-term return opportunities of a portfolio. The equity market is a good example of this. Anyone who invested solely in Europe over the past ten years would have achieved annual growth of 6.32% as measured by the MSCI Europe Index. However, those who diversified globally and relied on the MSCI World Index would have achieved an annual value increase of more than 10% over the same period. In other words, an investor who operates in a very narrow investment universe is missing out on long-term return opportunities.

The different types of diversification

Naive diversification

One of the first forms of portfolio diversification is known as “naive diversification”. In this approach, an investor simply seeks to diversify their portfolio across as many investments as possible, without considering the correlation between the individual investments. For example, an investor could invest in a broadly diversified range of technology stocks. However, as these tend to follow a very similar course, it is questionable what the diversification effect will be and whether this will actually improve the portfolio’s risk-return ratio.

Markowitz diversification

In the 1950s, the US economist and Nobel Laureate, Harry M. Markowitz, developed his “modern portfolio theory”. He demonstrated mathematically that broad diversification in the portfolio can reduce risk under certain conditions without investors having to accept lower returns – or, to put it a different way, that the return can be increased while maintaining the same level of risk.

In contrast to naive diversification, the key starting point is the aforementioned correlation between the asset classes or the individual securities included in the portfolio. This is measured using what is known as a correlation coefficient, which will be between one and minus one. A value of one indicates a completely positive linear correlation between two assets, while a value of minus one indicates that they develop in completely opposite directions. If the correlation coefficient is zero, the performance of the two assets is completely independent of one another.

The correlation matrix

The correlation matrix provides an overview of the correlation between different asset classes over time. The correlation between two variables is calculated using a mathematical formula. However, investors do not have to calculate these themselves as many correlation matrices are available on the Internet.

Such matrices, one of which is produced by J.P. Morgan Asset Management, for example, show that the correlation between US and European companies with high market capitalisation is 0.85, which is fairly high. Specifically, this means that if the S&P 500 rises by 1%, the MSCI Europe will go up by 0.85%.

In contrast, long-term US government bonds exhibit a negative correlation with all equity markets. An investment in US treasuries with long terms therefore offers a real diversification effect vis-à-vis equities, as US treasury bonds tend to rise when share prices fall. Gold also appears to be a good option; its correlation with global equity markets is just 0.1.

Investors can also diversify by investing at different times. A simple method is to set up a savings plan in which the investor invests the same amount at regular intervals, for example once a month, in an exchange-traded fund (ETF) or an investment fund. With such diversification over time, investors will buy more of the respective fund units when prices are falling, thus lowering their average entry price.

Tip: When saving for pillar 3 with securities, as is possible with relevate, this effect can be very easily achieved by dividing the annual maximum amount for payments into pillar 3a by 12 and then setting up a monthly standing order.

How can a portfolio be diversified with different asset classes?

The capital market does indeed offer a multitude of opportunities for building a diversified portfolio. In other words, it is now very easy to broadly diversify a portfolio across the various asset classes. The following section presents some of the most important asset classes and their diversification effects.

Diversification with equities

In the past, there has hardly been an asset class with higher returns than equities, which is why they are particularly suitable for long-term asset accumulation, e.g. as part of a buy-and-hold approach.

However, it is important that investors take advantage of the opportunities offered by the global equity markets on a broadly diversified basis, i.e. across sectors, countries and regions. Broadly diversified global equity indices such as the MSCI World or the FTSE All-World lend themselves to this. The MSCI World, for example, contains around 1,600 companies from 23 industrialised countries, while the FTSE All-World even includes 4,100 titles from both industrialised and emerging nations.

Warren Buffett’s criticism or how many shares ensure sufficient diversification

One of the most successful and well-known investors of our time, Warren Buffett isn’t fundamentally opposed to diversification, but he does advise against extreme diversification. A famous quote from Buffett can be paraphrased as: “Wide diversification is only required when investors do not understand what they are doing.”

He himself is regarded as a value investor who analyses companies very precisely and is thus in a position to reduce company-specific risks. In other words, he builds up a comparatively concentrated portfolio of just a few individual securities, which he scrutinises closely and monitors on an ongoing basis.

Anyone wishing to do this faces the question of how many shares are needed to ensure sufficient diversification. On this topic, Buffett once said (giving zero heed to political correctness): “Concentrate your investments, because if you have a harem of 40 women, you never get to know any of them very well.”

In other words, if you have too many individual securities in your portfolio, it is easy to lose track. For Warren Buffett, therefore, having 40 or fewer stocks in a portfolio seems to be enough for good diversification.

However, private investors who do not have the time, knowledge or tools to conduct a fundamental analysis of the market and individual companies are advised against using this methodology. According to the unanimous opinion of experts, these investors are much better off with broadly diversified and low-cost ETFs that reflect entire markets, regions or sectors.

Diversification with bonds

As equities may be subject to sharp price fluctuations in the short term, it makes sense to include fixed-income securities, also known as “bonds”. However, the different bond types exhibit varying degrees of correlation with the equity markets. For example, according to J.P. Morgan Asset Management, the correlation between US high-yield bonds and the global equity markets is relatively high, at 0.79. This means that the two perform similarly in the various market phases. On the other hand, as already mentioned, in particular US government bonds with long terms, whose value historically fluctuates less on average, are generally quite well suited for diversifying an equity portfolio.

Tip: A portfolio consisting of precisely these two asset classes, i.e. global equities and safe government bonds, is regarded as a fairly simple and well-diversified option.

With this in mind, the German magazine Finanztest developed the Pantoffel-Portfolio (“Slipper Portfolio”), which is now well known in specialist circles. It focuses precisely on these two asset classes and is intended to enable private investors to make the most simple yet diversified investment possible.

Diversification with real estate

Generally speaking, unlisted real estate companies are a good means of diversification, as they aren’t subject to daily fluctuations in market prices and therefore do not correlate with developments on the capital market. If a direct real estate investment is possible for an investor, therefore, this offers an opportunity to ensure a better risk-return ratio in the portfolio.

For listed real estate companies, the correlation coefficient between US REITs and global equities is 0.73, according to J.P. Morgan Asset Management. In other words, the correlation between them is relatively high and the diversification effect comparatively low.

Diversification with commodities and gold

Commodities and gold can also help to diversify a portfolio. Although neither direct commodity nor precious metals investments generate regular income, J.P. Morgan Asset Management states that gold has a correlation coefficient of less than 0.2 with the various equity markets and less than 0.5 with most bonds. The correlation between commodities and bonds is largely negative and between commodities and equities it is mostly below 0.5.

Time and again, we see investors looking to gold as a safe haven in particularly difficult market phases. In March 2023, for example, when a number of regional banks in the US got into difficulties and several of them had to close, the equity markets fell sharply whereas gold gained in value. Gold can therefore be a good diversifier, especially in times of crisis.

N.B.: The relevate strategies “modest” “dynamic”, “ambitious” and “maximum” include 2% to 4% “alternative investments” – a term which refers to an index fund that reflects the performance of gold.

Diversification with cash and currencies

Cash, i.e. account balances, can also contribute to the diversification of a portfolio, as it is not subject to price fluctuations and therefore does not correlate with equities, bonds or other asset classes. Cash also remains unaffected by capital market crises or recessions. However, it does lose value particularly sharply in real terms in an environment of high inflation.

Another element of diversification may be investments in currencies other than the investor’s domestic currency. One reason for choosing this option is that as currencies are always traded in pairs, it is never possible for all currencies to fall at the same time. Although it does entail exchange rate risks, a portfolio diversified by currency can protect against a sharp depreciation in the domestic currency.

Diversification with cryptocurrencies

Cryptocurrencies can be another source of diversification in a portfolio. Although most virtual currencies are still very young, meaning there is no long-term historical data, initial studies show that the correlation between Bitcoin and the S&P 500 was only 0.15 as of April last year. This ratio has risen to 0.5 since then, but cryptocurrencies can nevertheless help to diversify a portfolio more effectively and thus improve the risk-return profile.

Easy diversification with ETFs

How to achieve broad diversification with ETFs

One of the easiest ways to achieve broad diversification in your portfolio is to invest in ETFs. From an investor’s perspective, these products have various benefits. The fees are lower as ETFs only passively replicate an index, they can be traded daily on the stock exchange and they are generally considered to be very transparent. However, the potential value growth is limited. It corresponds to the performance of the underlying index less costs.

Another advantage is that broad diversification can be achieved very easily with ETFs. Not only are they available for a large number of equity indices, including the MSCI World and the FTSE All-World, but ETFs now offer investment opportunities on the bond market, too. This means that investors can invest in Swiss franc-denominated bonds with different maturities, as well as in Swiss government bonds, US government bonds or various global bond indices. In addition, ETFs now also offer gold as an alternative to physical investments – for example in some relevate strategies.

Sample portfolio

As risk appetite, investment objectives and investment term vary from person to person, there is no one-size-fits-all portfolio that suits every investor. However, a sample growth-oriented portfolio that could be implemented with ETFs might look like this:

• 60% broadly diversified equities, e.g. via an ETF on the FTSE All-World or the MSCI World
• 20% government bonds via an ETF on the Swiss bond market
• 10% gold either physically or via an ETF
• 10% cash

With this very simple sample portfolio, investors not only invest in four different asset classes, but are also well diversified in the equities themselves. Each of these areas can also be further diversified with additional investments, the weightings can be changed quickly and additional asset classes such as cryptocurrencies or commodities can be added.

Conclusion: there is such a thing as a free lunch

The saying “There is no such thing as a free lunch” is popular on Wall Street. In other words, every perceived investment advantage has to be paid for with certain disadvantages. For example, bonds from leading industrial countries are a very safe investment, but the price of this low risk is a lower average return compared to riskier assets such as equities. You incur opportunity costs. In turn, those seeking a potentially higher return have to pay for it with a higher risk. And so it is with all investments.

However, since Harry Markowitz, we have known that there is an exception. He said: “Diversification is the only free lunch in investing.” Private investors in particular should take advantage of this free lunch rather than falling prey to the misconception that they are the ones with a nose for investing and putting all their eggs into one basket. This strategy can work out and bring dream returns – but it can also result in very painful losses that cannot be made up in a lifetime.