Thanks to Diversification, You Can Improve the Risk/Return Profile of Your Investments

The stereotypical behavior of squirrels makes the animals known around the world for the way they “squirrel away” their food stores – a classic example of the need to ensure risk diversification in order to survive. The nuts are stored in various locations, rather than just one place, with the aim of being able to weather the winter well.

Sun Cream or Umbrella?

Investing everything in a single company, sector, or asset class involves risks – concentration risks, to be precise. In an optimal situation, the financial assets are distributed across the widest possible range of ideally uncorrelated risks (and opportunities).

Take the following example: We live on an island with just two listed companies. Rainy Corp. makes umbrellas, while Sunny Corp. manufactures sun cream. On the assumption that the rainy season is about to arrive, we will buy shares in Rainy Corp. If, on the other hand, we are expecting fine, sunny weather, we will purchase stock in Sunny Corp. in anticipation of higher demand for sun cream and therefore a rise in the company's sales.

The Better Investment Strategy: Diversification

Should either of these two sets of conditions (sun or rain) persist over a long period of time, one of the companies could be at risk of going belly-up while the other performs really well. Investing everything in a single company can be associated with a binary outcome: top or flop. Diversification in both companies is therefore the obvious course of action in order to reduce the risk of a total loss.

It gets a little more complex when we broaden the scenario. Let's assume the island now has a third weather scenario: cloudy and windy. A company that produces windproof jackets will be successful – and we realize that we probably need to diversify our portfolio further still. How strongly do we weigh the new company in our portfolio? Translating that across to the global financial market, we can see that the reality isn't that simple. On the one hand, the choice of different investments is virtually endless; on the other, we firstly need to determine the way different investments behave and the degree to which they correlate.

When Diversification Doesn't Pay

In technical terms, optimal diversification in an investment portfolio can be described as follows: The additional benefits of each new investment added to the portfolio should more than offset the additional cost. Each contribution thereby supports diversification and counts as additional benefits. It can be quantified by the change in the expected risk/return ratio. Additional costs can include transaction costs.

If, in the above example, the producer of windproof jackets were to additionally sell waterproof jackets, the umbrella manufacturer's diversification effect within the portfolio would decline. In this situation it might even be worthwhile thinking about whether to drop the umbrella manufacturer from the portfolio, especially since risk and return drivers are very similar to those of the jacket manufacturer in the event of wet weather conditions.

It is therefore important to make sure that the additional costs of each investment do not exceed the additional diversification effect and that the portfolio addition reduces the correlation of the investments. Otherwise the intended diversification can soon become too much of a good thing.

Diversification with Alternative Investments

Alternative investments are becoming increasingly attractive alongside bonds and equities, particularly in an environment of persistently low interest rates and returns. Alternative investments comprise a broad-based investment universe that includes hedge funds, real estate, commodities, and private equity.

Generally speaking, they do not react to the same influencing factors as traditional investments such as bonds and equities, thereby giving investors the opportunity to further stabilize their portfolio. A look at recent years shows that no asset class stands out in terms of higher returns; therefore, all asset classes need to be considered in a portfolio context.

Investment Strategy Determines Return and Risk

Empirical studies underscore this result: More than 80% of the risk and return on a portfolio is determined by its composition. Determining the strategic asset allocation (SAA) is therefore of utmost importance in the investment process.

Shorter-term tactical decisions and specific investment instruments obviously play a role too, but only once the fundamental structure of a portfolio has been created. The SAA is constructed based on the market expectations for the key asset classes. These cover returns, risks, and respective correlations.

Long-Term Return Thanks to Optimal Diversification

In accordance with the wise words of US economic scientist Benjamin Graham ("Patience is the investor's greatest virtue"), taking a long-term view is enormously important and a core element of any investment strategy. Individual portfolios should in all cases be diversified and the asset allocation tailored precisely to the investor's individual risk tolerance and investment horizon.

Asset management solutions such as investment funds and mandates ensure that the principles of diversification are adhered to and that SAA as well as tactical investment opportunities are implemented. If the portfolio is composed of individual investments, it is important to ensure that each additional investment brings the greatest possible diversification effect. Your relationship manager can help you select and evaluate the right products.