Meaning of Diversification

By | May 16, 2021

Diversification is an important measure when it comes to reducing risk. This applies in many areas of life – but especially when it comes to investing. If you have a well diversified portfolio, you can reduce the risk of loss and still take advantage of potential returns.

  • When it comes to diversification, there are several options. That lowers the risk of loss.
  • Diversifying the portfolio helps stabilize returns and avoid extreme losses.
  • If you set up your portfolio broadly, you can count on a favorable return development.

Diversification explained in simple terms

Those who diversify rely on several options to reduce the risk of failure. Should an option develop into total failure, this loss can be cushioned with successes in the other fields of action. This approach can be found not only in the investment strategy, but in many areas of everyday life.

Diversification in nature and agriculture

Diverse ecosystems are an example of how nature secures the continued existence of the habitat through diversification. Very different plant and animal species form a complex interrelationship – and that works as long as a single form of life does not dominate the entire system.

Agricultural experts have long recognized that diversification can reduce the risk of loss. Wherever monocultures arise, everything can be lost in the event of a bad harvest. By contrast, those who grow a large number of different crops can significantly reduce the risk of total loss.

Diversification in business

In business life, too, it is considered risky to put everything on one card. When a company becomes dependent on a single product, profits will bubble as long as demand is high. However, as soon as a competitor offers a better alternative, the very existence of the entire company is all too quickly endangered if sales figures decline.

The same applies to the dependency on a single major customer. Forward-looking entrepreneurs therefore always make sure not to become too dependent on a single product or individual customer.

Advantages and disadvantages

If you keep several options open, you benefit from an important advantage: the probability that all fields of action lead to a total loss is negligible. In addition, an unfavorable development in one area can often be compensated for with a particularly good development in another area.

The disadvantage is that with diversification, the total return is always lower than the return that would have been possible with the most profitable field of activity.

That means: If you rely on several alternatives, you lower your risk of loss and buy it by foregoing the highest chance of winning.

What does diversification bring in terms of investments?

When investing money , the higher the chance of a return, the greater the risk of loss that you as an investor take on. Conversely, secure forms of investment are usually not very profitable.

For example, if you choose a savings bond with a bank based in Germany, you will not run the risk of loss thanks to the deposit protection. But for that you have to be content with a low return .

You will have better chances of winning a share whose performance in good stock market times can outperform the savings bond return many times over. But when the stock market is low, such investments bring losses.

This is where diversification comes into play by distributing safe and risky investments in such a way that, when viewed as a whole, a good return is expected with a manageable risk.

How you can mix different asset classes

According to digopaul, the first step in diversification is to distribute the investment capital across different asset classes. First and foremost, it is about safe interest rate investments and riskier securities. The list shows you which investment products belong to which asset class.

  • Income investments: call money , time deposit , savings account , savings bond , savings agreement
  • Securities: stocks, bonds, mutual funds , index funds ( ETFs ), investment certificates

When you mix interest-bearing investments and securities, you should take the time factor into account. The longer you hold an investment, the more the fluctuations in value of risky investment products will even out over the years. Conversely, you should avoid the risk of loss if you know that you will need the money again in the foreseeable future.

Two important rules for diversification can be derived from this:

  1. For the money you need in the next few years – for example to buy your next car – choose secure forms of investment such as overnight or fixed-term deposits.
  2. For long-term investments, depending on your personal risk appetite, you can also rely on riskier investment products such as investment funds, with which you can simply sit out bad times on the stock market and benefit from the long-term return opportunities.

With this strategy, you achieve a far more favorable ratio of return opportunity and risk than an investor who would simply mix interest-rate investments and securities at random.

Diversification within the securities portfolio

Within your securities investments, you should make sure that your individual risks are distributed as well as possible. Specifically, this means:

  • Don’t make yourself dependent on a single stock
  • spread your stock investments across multiple industries and
  • take into account the world’s most important economic regions.

If you put all your share capital in just one company, your money would be lost if the company had to file for bankruptcy. This risk of total loss is almost zero if you distribute the capital among different companies – because the probability that all of them will go bankrupt at the same time is negligible.

When distributing it across various industries and economic regions, the aim is to avoid so-called cluster risks.

Example: An investor only owns shares in German automobile manufacturers. In addition to the usual share price risk, he runs the risk that his losses will be particularly high if the automotive industry is struggling with problems or if economic development in Germany is worse than in other industrialized countries.

Effect for the portfolio

Those who diversify their securities investments can improve the ratio of the return opportunity to the risk of loss. Financial scientists have found out that the diversification of a portfolio greatly reduces the risk, while the return expectation compared to a single share only declines slightly or even remains the same.

This effect is particularly strong if you buy several different stocks instead of a single stock. If, on the other hand, an investor already owns a large number of well-diversified stocks, buying additional stocks will only reduce the risk slightly.

Example of security diversification

Suppose an investor wants to invest 35,000 euros in stocks, investing 5,000 euros per company. This means that he can distribute his capital over seven stocks, which he could select as follows:

  1. An automobile manufacturer from Germany,
  2. a financial group from the Netherlands,
  3. a telecommunications company from Spain,
  4. a pharmaceutical company from Switzerland,
  5. an internet company from the USA,
  6. a trading company from the USA,
  7. an electronics company from Japan.

With this mixture, he distributes his capital both to different industries and to the important economic regions of Europe, North America and East Asia. Even if this does not yet cover all economic sectors and countries, it is to be expected that in the long term the fluctuations in value of the overall portfolio will be significantly lower than for individual stocks.

Tip : If you don’t have enough capital to build multiple equity positions, consider investing in the stock market using mutual funds. As a fund investor, you can also invest small amounts in a portfolio that often includes more than 100 individual stocks. Equity funds that invest worldwide and across all industries are particularly recommended for the basic investment.