Tips to reduce the risk in your portfolio
Anyone who bets all their money on a horse on the racetrack will either be a champion or a loser at the end of the race. It is no different on the stock exchange. Anyone who invests their capital in a single stock value and the company gets into a financial distress that threatens its existence runs the risk of losing all of their money. For highly speculative investors, a complete loss of money may be an acceptable scenario. Normal investors don’t want to imagine that. Exchange experts advise you to diversify (including diversification). The capital should be appropriately distributed over several shares and areas with the aim of significantly reducing the investment risk in a securities account through diversification. Investment experts cite an order of magnitude of the risk reduction of 20 percent to 30 percent. Investors can achieve this with different diversification strategies. We would like to explain in more detail what these are and what investors should pay attention to in our stock portfolio diversification guide.
- Diversification is a prerequisite for less risk
- Different diversification strategies applicable
- Own investment strategy provides diversification strategy
- Reduce the risk of losing your own portfolio by selecting stocks
Equity portfolio diversification: explanation
In the opinion of many stock market experts, diversification (also diversification) of an investment portfolio is not just an option, but a necessity. It is considered to be one of the most important factors in long-term investments. The classic investment theory regards diversification as the ultimate in protection against losses.
What is meant by diversification is the distribution of investments over several sectors and investment stocks, depending on the return target and risk tolerance of the investor. This ensures risk diversification, which in turn is the basis for optimally structuring risks for your own portfolio. The well-known equestrian saying “Never put all your money on one horse!” More than clearly underscores the risk of loss if you focus too much in the event of a wrong prognosis. As with any long-term investment, the investor in the stock market should strive to distribute his capital sensibly between different companies. If a company goes bankrupt, only part of the assets would be affected. Without a corresponding division, all capital would be destroyed.
If an investor wants to generate a higher return, most of the capital is invested in stocks, the remainder in safe government bonds. A defensively oriented investor will make his investment decision the other way around and invest less in stocks. Basically, the following applies to the investor: The desire for more return requires taking a higher risk.
What can and cannot be achieved with diversification
In order to answer the question “What can and cannot be achieved with diversification”, the effects of diversification have to be considered. Greater diversification means that a return on the overall portfolio depends less on individual decisions. This reduces the range of fluctuation in the portfolio.
However, the result is not ideal. A wrong decision will reduce the negative impact. However, this also applies in the opposite case, if good decisions have been made. The positive effects are correspondingly lower.
Diversification ensures average investment results within a specific portfolio. If the investor makes poor investment decisions for the most part, diversification will not lead to good results. His investment result will then be average and not absolutely bad.
The selection of good and cheap stocks is crucial for the potential return. With diversification, you can ensure that the effects of wrong decisions do not end in disaster. It is well known that no investor is immune to wrong decisions. For reasons of diversification, it makes no sense to buy less promising stocks.
Diversification & correlation of financial instruments
An investor should be familiar with certain relationships that are caused by the correlation between financial instruments. If the gold price rises, this is mostly due to falling share prices (negative correlation). How strong the price increase of the precious metal will be when stocks are falling can only be speculated about. The same thing happens when interest rates rise. Then the prices of bonds fall. If the share price rises, the oil price rises too (positive correlation). Taking into account the correlations of certain financial instruments, the portfolio can be designed, which theoretically completely excludes a market risk.
Dividing the capital over a few stocks and spreading the risk does not cost the investor much effort. The added value that can be achieved is considerable. Does the problem arise how investors achieve the optimal diversification of their portfolio? In practice, diversification is not that easy to achieve. In addition, there are successful stock market gurus who turn some stock market wisdom about risk minimization through diversification upside down or see and approach it differently.
How many stocks there should be
How many different stocks do you need for a diversified portfolio? As is so often the case with financial investments, there is no one true answer, if it is supposed to be right for every investor. One thing is certain: it is not enough to just buy two dozen different stocks.
Experienced investors need a few stocks in their portfolio with which they can achieve a good mix of several industries. Such a depot is also called “concentrated” in stock exchange German. The development of individual stocks has a major impact on the entire portfolio. And when investors like Warren Buffett are often right, they can quickly take advantage of large profits.
However, concentrating on a few stocks can ultimately lead to the hoped-for profit failing to materialize and capital being lost. A single bad object in the depot is enough to ruin the entire balance sheet. The risk of loss with so few stocks is correspondingly higher. In order to spread the risk or to be better diversified, many investors buy different papers.
How many stocks should there be?
There is no general answer to how many shares should be kept in the custody account. First and foremost, it depends on the respective investor. Factors such as:
Size of the portfolio: Anyone who has invested more capital has to deal more with questions of diversification. One or two good stocks can be bought for 1,000 euros. At 10,000 euros, the financial leeway is much higher.
Favored investment horizon: A long investment horizon is an advantage for increasing capital. Market risks play a less important role. Those who want to live from the capital should be diversified differently (high risk diversification) in order to be largely armed against market risks.
Long-term desired return: There are financial products on the market with which the general market return can be achieved over a longer period of time. This works well with an ETF savings plan (share savings plan). In addition, the investor can benefit from the low coverage effect here. If the aim is to achieve a return above the market level, maximum diversification is counterproductive if only the market return is achieved.
Willingness of the investor to take risks: An investor must feel comfortable with his investment. Market movements with falling prices must not lead to panic and wrong decisions. If the capital is invested in five stocks, 20 percent of the capital is lost in the event of bankruptcy. If the money is distributed over 10 shares, the loss if a company goes bankrupt is limited to 10 percent. The investor has to find out what is right for him. Advice from third parties that he needs more or fewer shares does not help here.
Diversification is a prerequisite for less risk
There are two different approaches to strategy among value investors. While some prefer portfolios with a few investment stocks, others have broadly diversified their investments. Both strategies, when used correctly, lead to good long-term returns with the lowest possible risk.
Portfolio diversification is never an end in itself. Rather, every investment is bought because of its existing qualities. Value investors do not care about the market risk itself, because they rate an investment according to the specific risk. They use a strategy that is based on the valuation of the stocks at a given point in time. Growth and value don’t have to be a contradiction in terms. In value investing, successful investing means that a base value of 10 euros is bought for less than 10 euros and sold again for at least 10 euros or more. Alternatively, it would also be possible to hold a company with corresponding distributions (dividends, share buybacks).
Diversification like Warren Buffett
Warren Buffett once said that for him diversification is a protection against ignorance. Diversifying makes no sense for investors like him because they know what they are doing. Star investor Buffett believes that too much diversification is at the expense of performance. For this reason, he concentrates his capital on a few company stocks and knowingly selects the best for his investment.
In 1965 he bought several hundred shares in the Berkshire Hathaway textile company for $ 15 each. A share capital of then $ 5,000 would have grown to $ 93 million in just over half a century. Anyone who has such a share in their portfolio does not have to worry about the composition of the portfolio. Nobody can look into the future, but the return can lie in this very same
Investing like Warren Buffett is likely to pose a dilemma for most private investors. Undoubtedly, it is possible to achieve higher returns over the long term with a few selected stocks. Private investors, however, are likely to have difficulties accessing the knowledge and analysis options of a successful stock market guru. Warren Buffett does not do his company analyzes alone, he employs a large number of people and can look back on a career on the stock market spanning decades. Comprehensive analyzes cannot be carried out by the individual investor in their annual free time. For obvious reasons, young investors lack experience and knowledge.
Advantages of low diversification
Representatives of the classical investment theory praise diversification at every opportunity. There is no doubt about the importance of the topic. Every investor should consider a certain diversification. That doesn’t mean he is overdoing it. He has to find the right measure. He should keep in mind that less diversification has its advantages.
Less diversification — lower costs
Diversifying a portfolio means buying additional financial products, incurring transaction costs. High diversification inevitably means higher costs. It does not matter whether these are pure transaction costs or, as with ETFs or equity funds, annual fees. The long-term impact of these costs is enormous. Every euro paid to a third party diminishesthe possible future return.
Decades of investment result in considerable sums of money due to the compound interest effect. Financial experts have analyzed the investment fees and the effects on compound interest and found that, for example, equity funds destroy a third or more of the return via the fees. If you get high transaction costs from your broker or custodian bank, you should switch to a cheaper provider. A depot change is free of charge and takes place without any bureaucratic effort.
Less diversification — less time investment
Anyone who has bought cheap, high-yielding stocks can leave them unobserved in their stock portfolio for a long time. Reallocations tend to be counterproductive and only cost additional money. Very few investors will care or have actually bought the cheapest stocks. A regular check of the depot is recommended. In this regard, the companies or ETFs that have been bought must be reassessed from the investor’s perspective. If there are only a few positions in the depot, the depot check takes correspondingly little time.
Higher returns are possible
Concentrating on a few assets has the advantage that the really profitable companies are kept in the portfolio. There are usually no higher returns when the whole market is bought. For a higher return, the investor must concentrate on the best financial products. Less good stocks are often included in indices simply because it has to be because of industry mirroring. Many stock indexes contain companies that are more of a hindrance to good returns.
Some investors feel more comfortable with 10 to 20 top companies than with a basket of 50 or 500 shares. Given the large number of shares, details on individual companies in their entirety can hardly be made out.
Conclusion on diversification share portfolio: a prerequisite for less risk
Diversification is a prerequisite for less risk. So it is important. Multiplying the number of shares does not simply mean more security. Diversify properly is the key word. Too many stocks ensure at some point that security can no longer be increased. In addition, there are higher trading fees and increased administrative expenses for the custody account. That hardly justifies the additional security gained. Experienced investors do not have to diversify their portfolio widely. With just a few selected stocks, you can achieve risk diversification through a good mix of several industries.
Every investor should study diversification carefully. He has to determine for himself and his portfolio how useful diversification is. The investor alone knows financial goals, investment horizon and willingness to take risks. On this basis, he must choose the right investment strategy. Determining from the outside how many and which stocks and asset classes the portfolio portfolio should have harms the investor. If he is not comfortable with it, he will make mistakes and these can be expensive. Anyone who has long-term confidence in the stock market should concentrate their investments on stocks. Larger positions in gold or bonds are to be avoided because they bring less return than stocks. Most of the returns come from investing in the best public companies.
It is very easy to diversify with equity funds (actively managed equity funds, passive products / ETFs). Active funds are not optimal in terms of fees, which a well-managed fund can make up for. The alternative would be to buy ETFs through a stock savings plan.