What is diversification? Risk distribution in a nutshell

Diversification is a big buzzword in the world of investment – and a particularly important one. Those who invest in a diversified manner can minimize risk and still generate profits.

Investing money is worthwhile – especially if you want to make more of your own assets. What is not worthwhile, however, is to put all of your investment capital into just a few investments, for example only investing in three or four stocks. This is because in doing so investors are taking a high and unnecessary risk.

What does diversified investing mean?   

Fundamentally, diversification is quite simple:

• Investing money in equities means buying shares in companies
• Investors hope that the companies in which they hold shares will make a profit – because this usually increases the value of their shares.
• For the chance of a return, investors also have to take a risk: The risk that the companies they have invested in will post losses or even go bankrupt.
• If a company goes bankrupt, investors have to accept losses in their portfolio
• If you have a poorly diversified portfolio with shares in (for example) only four companies, you will feel the pain if one of these four companies goes bankrupt
• If you have a well diversified portfolio with shares in 50 companies, the bankruptcy of one of these companies will be much less noticeable

In other words: It pays to spread your invested assets as widely as possible. However, this does not just mean buying shares in many companies. A good diversification strategy should take place on many levels, for example in:

• Different asset classes such as equities, bonds, precious metals
• Different sectors, currencies, regions

Finally, you are also taking a risk if you hold shares in a number of different companies but they are all in the same sector – for example in the tech industry. Or if you are only invested in one region and the local economy experiences a crisis. The broadest possible diversification is therefore essential to minimize the investment risk.

Spreading risk: This is why diversification is so important

If you have a diversified portfolio, you can spread the risk across different investments and thus minimize it. But what does the word “risk” actually mean? What risk are investors effectively taking when they invest?

All securities have two types of risk:

• Market risk (also known as systemic risk)
• Individual risk (also known as non-systemic or security-specific risk)

Systemic or market risk is always present. It is a risk that all investors must take. Major world events, such as the 2008 financial crisis or the COVID-19 pandemic, influence developments on the equity markets.

Individual or non-systemic risk exists for every security. A company is poorly managed and goes bankrupt? Another company enters the market and offers a massively better product? Laws change and make it difficult for a company to continue operating? These things can always happen. However, with the right diversification strategy, investors can reduce their individual risk to a minimum.

Funds and ETFs: Diversify even with small amounts

The smaller the amounts invested, the more difficult it is to broadly diversify a portfolio – at least if you want to invest directly in equities and bonds. Investors who do not want to invest huge sums but still want to diversify are well advised to invest their money in investment funds or ETFs (exchange-traded funds). Investment funds and ETFs already contain a range of securities, sometimes also asset classes, and are sometimes invested across different regions or in different sectors. This ensures good diversification even with small amounts. If you want to minimize risk even further, you should also stay invested for as long as possible, not be distracted by price fluctuations and only invest as much as your own risk profile allows. Coupled with smart diversification, nothing stands in the way of the prospect of returns with minimal risk.