Financial knowledge

What exactly is diversification?

Anyone who wants to invest long term should diversify their portfolio. This latest article in the "Three questions for ..." series explains why investors should diversify and what that means, exactly.

Data
Autore
Tilmann Schaal, LGT
Tempo di lettura
4 minuto
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What does an ideal portfolio look like? There is no one answer to this question, because when building an investment portfolio, competent investment professionals will always try to balance risk and return opportunities in a way that corresponds with a person's individual needs.

Diversification is a way to minimize certain risks. Thomas Wille, Chief Investment Officer (LGT Private Banking Europe), explains how it works - and what investors stand to gain from it.

Not putting all your eggs in one basket.
Thomas Wille (LGT) on diversification: "not putting all your eggs in one basket." Photo © iStock/Bonchan.

Diversification plays a very important role in efficient asset allocation. Can you explain what that means for investors?
Diversification is a key component of the American economist Harry Markowitz's Modern Portfolio Theory (MPT). Markowitz received the Nobel Prize for this model, which he developed in the early 1950s. Today, he is considered the father of efficient asset allocation.

Put simply, diversification means not putting all your eggs in one basket. But that isn't something that investors should do intuitively. Instead, you need to distinguish between systematic and unsystematic risk.

Systematic risk is the risk of fluctuations in the broader capital markets and cannot be reduced through diversification.

Unsystematic risk can be eliminated through proper diversification.

Thomas Wille

Unsystematic risk, or the risk of fluctuations in individual stock prices, on the other hand, can be eliminated through proper asset allocation or diversification. For example, if you have a portfolio that initially consists exclusively of one stock, and the investor then diversifies this portfolio by investing globally in 20 different stocks, the unsystematic risk can ideally be reduced by more than 90 percent.

Relationship managers often recommend that their clients broadly diversify their portfolios. Why is this so important?
The term broad diversification generally refers to allocating assets according to various criteria, including different asset classes, sectors, countries, currencies and other factors. The reason for doing this is to reduce risk and achieve a better return.

 Ensuring you have properly diversified your investment building blocks
Thomas Wille (LGT): "We firmly believe that ensuring you have properly diversified your investment building blocks is more important than ever in the current environment." Photo © istock / Andrey Popov.

The goal of asset allocation is to invest in different portfolio components with a low or negative correlation. This is done in an effort to ensure that fluctuations in one asset class or asset component do not impact the other elements of the portfolio.

Ultimately, the aim is to offset potential losses in individual asset classes, sectors or currencies with gains in other areas through the skillful allocation of assets. This can improve the stability of the overall portfolio and increase the risk-adjusted expected return.

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Considering how interconnected and complex things are today, is diversification still an effective tool – or is it a thing of the past?
My colleagues and I firmly believe that ensuring you have properly diversified your investment building blocks is more important than ever in the current environment. We are convinced that the right diversification - that is, a portfolio with several uncorrelated building blocks - continues to offer better risk-adjusted returns.

There is no doubt that the globalization that has taken place over the past 20 years has increased correlations within regional equity markets and reduced the benefits of a globally diversified equity portfolio. However, we believe that portfolio diversification continues to pay off.

When we are looking to diversify, we don't just focus on global bond and equity markets, but also integrate investments such as hedge funds, liquid alternatives and commodities with a traditionally low correlation into the portfolio. In particular, we believe investors can improve diversification with private market investments, such as private equity, private real estate, private infrastructure and private debt.

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