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Created on 07.11.2018

Diversification: this is how it works

Every investor out there has probably heard of diversification. It is the foundation of a successful investment strategy. Why? Because by spreading out investments, you can minimise the risks you take up to a certain point, and by doing so, you can get more from your money.

Any investor knows that putting all their assets in one basket is just not a good idea. If you are looking to invest in securities successfully, you should spread your assets between different investment tools, industries, currencies, countries and regions of the world. Diversification is the keyword here. You can find out exactly how it works in the article “Diversification - why you shouldn't put all your eggs in one basket".

But just why is diversification so important? A diversified portfolio will help to spread risk, and ultimately minimize it altogether. Financial theory distinguishes between systematic risks and unsystematic risks. Systematic risks are essentially unavoidable. Any investor must hazard the risk of things like political events or natural disasters having a negative impact on the stock market. This is why investors get premiums, after all. Specifically, they get what is known as a risk premium: in simple terms, risk premiums are a sort of reward investors receive for picking a riskier investment over a safer investment. It is not paid to the investors directly in cash, but factored into the investment’s payouts. Unsystematic risks (e.g. the risk of a loss because of a company going out of business), on the other hand, can practically be avoided altogether by diversifying. This is precisely why you should not solely invest in individual companies or industries so that you can offset potential losses with other investments. The smaller the correlation between the investment categories you choose, in other words the more they differ, the greater the diversification effect.

It’s the mix that does the trick

The following example shows us exactly how diversification works. Let us assume we are investing CHF 10,000 in 1999, with an investment horizon of 18 years, in three different portfolios. Our return will equate to the yearly return in percent. We calculate the risk by working out how much higher or lower our returns were compared with the average figure.

Let us compare the three portfolios: 

  • Swiss shares: we are only investing in Swiss shares according to the SMI. This will give us a return of 3.83% a year, which means we are taking a moderate risk. 
  • Emerging markets: We are only investing in shares from emerging markets. This will give us a higher return (4.50%), but the risk is considerably greater (21.1%).
  • Mix of shares: We are investing CHF 5,000 in emerging markets and CHF 5,000 in Swiss shares. This will give us a slightly higher yield than if we were just investing in emerging markets, and so the risk we run is reduced significantly (15.8%). 

Investment categories/portfolios Initial capital (1999) Final capital (2017) Return Risk
Investment categories/portfolios
Swiss shares (SMI)
Initial capital (1999)
CHF 10,000
Final capital (2017)
CHF 19,656
Return
3.83%
Risk
13.8%
Investment categories/portfolios
Shares in emerging markets
(MSCI World Emerging Markets)
Initial capital (1999)
CHF 10,000
Final capital (2017)
CHF 22,086
Return
4.50%
Risk
21.1%
Investment categories/portfolios
Mix of shares (50% each)
Initial capital (1999)
CHF 10,000
Final capital (2017)
CHF 22,161
Return
4.52%
Risk
15.8%

So far, so good. By diversifying, we have already managed to optimise our share portfolio. What would happen, though, if we went for another investment category? Let us take a closer look at the bonds. 

  • Bonds: We are only investing in various bonds. We would usually be taking a very low risk of 4%, though this would give us our lowest return so far. 
  • 60% mix of shares, 40% bonds: we are combining our successful mix of shares with our safe bonds. This would produce the biggest return (thanks to the shares) at a significantly lower risk (thanks to the bonds). 

Investment categories/portfolios Initial capital (1999) Final capital (2017) Return Risk
Investment categories/portfolios
Bonds
Initial capital (1999)
CHF 10,000
Final capital (2017)
CHF 19,174
Return
3.68%
Risk
4.0%
Investment categories/portfolios
60% mix of shares, 40% bonds
Initial capital (1999)
CHF 10,000
Final capital (2017)
CHF 22,344
Return
4.57%
Risk
9.2%

Smart diversification is half the battle

The same applies to daring and cautious investors: diversify! Even if you generally like to take risks, a degree of smart diversification will help you get more from your investments, just as our example illustrates. 

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