Portfolio diversification: How to reduce your investment risk

Learn what portfolio diversification is and how you can enhance your portfolio’s resistance without missing out on yield opportunities.

“The higher the yield opportunity, the higher the risk of an investment.” This rule of thumb is familiar to most investors, and it is true – at least in part. What it fails to mention are the consequences for investors when the risk actually does occur; risk should be understood as the interplay of probability of occurrence and impact. An example: an investor wants to play it safe and therefore chooses the safest form of investment, a savings or money market account. While both offer next to no return, they are regarded as safe, with an extremely low probability of loss. However, a situation in which the default risk does become a reality – that is if, in the case of a cross-border bank crash, the banks’ deposit protection is insufficient – may in fact affect an investor’s entire savings. 

Stock investments bear a significantly higher potential for profit, but extreme cases can also result in total loss, a fact most recently seen in the Wirecard case. The situation is quite different if investors spread their assets across various securities, possibly including an ETF (exchange-traded fund). Even if the basic risk in terms of probability of occurrence were the same for individual securities, the theoretical effects on the investment as a whole are by no means as drastic. This brings us to the subject of portfolio diversification, i.e. the art of pursuing a targeted return while significantly reducing the risk of loss.

A clever mix of asset classes

“Don’t put all your eggs in one basket” is an age-old stock market wisdom which every private investor should adhere to. For obvious reasons, a financial investment that focuses on different areas carries a significantly lower total risk of loss for an investor’s portfolio. However, in terms of both risk diversification and performance, the types of financial products that investors choose to add to their portfolios are by no means irrelevant. Experts call this interplay “investment teamwork”.

Asset classes suitable for diversification

Before looking at correlations, i.e. the mutual relationships and dependencies, between the various forms of investment, an overview of the asset classes in question should be established. Basically, hedging instruments such as overnight money and time deposits as well as euro government bonds can be labelled as safe, while stocks, government bonds of emerging markets, real estate and commodities are far riskier yield drivers.

Diversification within asset classes

Risk diversification within an asset class is of course also possible – think of stocks from industrialised countries versus those from emerging markets. The latter bear much higher growth potential, but are also incomparably riskier as investments. For instance, the political climate in the respective country may be less stable than in Europe or the US. The same of course applies to government bonds and, even more so, to corporate bonds from various regions. International high-yield bonds issued by companies with low credit ratings, so-called high-yield bonds, offer higher yield opportunities alongside a much higher risk of loss than emerging market bonds, which in turn offer higher yields but are riskier than bonds issued in industrialised countries. 

Equities and corporate bonds from various sectors are also suitable instruments for diversification. According to investment strategy magazine Fairvalue, the shares of international food companies have withstood all crises since the turn of the millennium, while stock market crashes saw shares of medium-sized and large companies in the industrialised countries suffer losses of more than 50 per cent.

Observe correlations, avoid false diversification

To spread a portfolio’s investment risk in the best possible way, it is important that the selected securities and asset classes maintain the lowest possible correlation to each other. A correlation between two investments can range from 1 (both develop in the same direction in certain market situations) to -1 (they develop in the opposite direction in certain market situations). 

False diversification occurs when different investments within a portfolio correlate strongly, i.e. investments have been spread across a number of different asset classes without actually reducing the risk, because all portfolio components perform similarly. European stocks, for example, which according to MultiAsset.com not only have a correlation of 0.75 to US stocks and of 0.73 to emerging market equities, also have a correlation of 0.77 to European high-yield bonds and 0.56 to European investment-grade corporate bonds. A much better-suited option to diversify a portfolio of European equities: euro government bonds, with a correlation of 0.15, and gold, which has no correlation at all.

ETFs help hedge investment risk

ETFs are extremely popular among private investors, and with good reason. Rather than focusing on individual stocks, they invest in an entire market or sector. However, diversification with ETFs is only successful if, in analogy to risk diversification with individual securities, attention is paid to the lowest possible correlation between the sectors and markets which the index funds are based on. To a certain extent, however, adding ETFs to a portfolio can certainly help reduce investment risk. An ETF on the German benchmark index DAX for example can offer effective protection in the event of a slump in individual sectors. If the overall German economic situation worsens, this protective effect is, however, greatly reduced.

Individual stocks vs. DAX during the pandemic

The positive effect of portfolio diversification becomes impressively apparent when comparing the DAX as a whole to its individual components. In the first half of 2020, the shares of sportswear manufacturer Adidas dropped 16.32 per cent, BASF shares lost 20.36 per cent, and Bayer shares also lost 20.25 per cent in value. The shares of carmakers Volkswagen and BMW also saw a sharp decline by a respective 19.42 and 12.69 per cent. Over the same period, however, the German benchmark index fell by just under 11 per cent overall. Despite the global economic crisis caused by the pandemic, the poor performance of individual DAX stocks was therefore at least partially offset by the diversification “automatically” included in the index. 

The special role of gold in times of crisis

It is hard to imagine a diversified portfolio without gold. In addition to the function of the precious metal as a hedge against inflation and a safe haven in times of crisis, a 5 per cent admixture can also have a stabilising effect outside of crises. It can contribute to performance, especially in today’s low or negative interest rate environment, where money market offers are currently no competition for gold. However, the precious metal usually reaches its highs in times of crisis, when the correlation of gold to asset classes such as equities can turn from a neutral position to a negative one. Proportionally, the gold price develops inversely in this case, as evident in a comparison of the performance of gold with the development of the DAX during crisis. 

DAX vs. gold during the pandemic

On 22 January 2020, the DAX reached a new all-time high at 13,640 points, and gold stood at 45.15 €/gram on that day. Five days later, on 27 January, the first COVID-19 case in Germany became known. In the course of the global spread of the virus and the contact restrictions imposed in Germany and many other countries, the German benchmark index plummeted. It reached its lowest point on 18 March at 8,441 points, but has since recovered. With the end of the lockdown and the easing of restrictions for many sectors and industries, the DAX has worked its way back up to 12,313 points in expectation of a V-shaped economic recovery by the end of July 2020. Gold stood at €53.08 at that time. While the DAX, as already mentioned, lost just under 11 per cent despite a strong recovery, gold gained just under 18 per cent and thus once again proved its stabilising effect during a crisis. In mid-March, gold prices saw a temporary setback, crashing after stock markets around the world collapsed. This was due to the fact that a number of major investors exited the futures markets, liquidating their gold holdings to cover stock market losses. 

Conclusion: diversification should be applied to every portfolio

An intelligently diversified portfolio enables investors to withstand slumps in certain sectors or regions much better than a handful of individual securities ever could. A successfully diversified portfolio does not always have to contain a mixture of real estate, commodities and securities. However, individual stocks make little sense for smaller investments, and private investors are usually better off choosing ETFs, as index funds cover a broader investment spectrum and can achieve a certain degree of diversification. It is also advisable to add gold as a safe haven in times of crisis (such as the current pandemic). A quantitative analysis by management consultancy Mercer Germany shows that even with an assumed 15 per cent probability for a crisis scenario, a 5 per cent admixture of gold to a portfolio represents a sensible diversification. In the study, the profit and loss opportunities of an equity and bond portfolio were compared with those of an equity, bond and gold portfolio. The Mercer study shows that any targeted return within the defined spectrum is just as achievable with a portfolio containing gold as it is without gold. However, at the same time, the risk of loss is lower for a portfolio containing gold than it is for a pure equity-bond portfolio.

Arnulf Hinkel
Financial journalist