- Investors should never invest their capital in a single stock but always spread it broadly across multiple asset classes.
- This means, any losses from particular securities can be offset by gains in another investments.
- Risks can be further minimised by including different sectors and regions in a portfolio.
Market wisdom check
The well-known US economist Harry M. Markowitz once said that diversification is the only thing you get for free in investing. Free? That sounds good. But what exactly did Markowitz mean? And, most importantly: was he right?
Imagine if you were given a certain account of money to invest. You can invest it in a single stock or a basket of different securities. What would you do?
For most investment professionals, the answer is simple: they would go for a comprehensive basket of securities, no matter how promising they thought the single stock looked. But why?
It’s a stock-market rule that investors should never invest their money in a single stock but always spread it across several investment products and asset classes. Investment experts call this “diversification”. Markowitz studied this subject in depth and in 1990 he was awarded the Nobel Prize in Economics for his portfolio theory. He spoke of diversification as the “only free lunch in investing”.
A simple example illustrates what Markowitz meant. Research has shown that many investors tend to allocate a disproportionately high amount of money to their home market. Professionals call this phenomenon “home bias”.
Imagine there’s an economic downturn in country A, while country B’s economy is booming. Home-bias portfolio A would go down with country A, while home-bias portfolio B would soar. In a balanced portfolio with securities from both countries, gains from investments in B would offset losses from investments in A.
A broad capital spread can minimise the risk of losses
“What Markowitz meant was for free was not diversification as such but the positive effect that investors buy when they diversify,” says Henning Postada, fund manager at DWS. “With a broad capital spread, investors can, on the one hand, reduce the risk of losses, and, on the other, enhance their returns.”
This is because the improved asset mix also changes the portfolio’s risk/return profile. Markowitz was able to show that it is possible to build portfolios where the expected return is greater than the average return on single stocks with the same level of risk. It is likewise possible to build a portfolio that has the same expected return but with lower risk. In both cases, the risk/return ratio changes in favour of the investor. This is the “free lunch” that Markowitz mentioned.
“Good diversification is about far more than avoiding regional bias,” says Potstada. Investors should also ensure that they think about including different sectors in their portfolio. If global demand for cars should dip, for example, car manufacturers and suppliers – and these companies’ shares – would suffer. In other sectors, such as food or finance, by contrast, this would not have a negative effect.
Asset distribution across different asset classes is key
“However, the most important thing in diversification is to get the right mix of different asset classes, such as shares, bonds, currencies and commodities,” says Postada. According to research conducted by the DWS Research Institute, this accounts for around 90 percent of a portfolio’s performance. “But there is no generally applicable rule as to how investors should structure their portfolios in terms of shares and other asset classes,” he clarifies. “That depends on the specific person, their investment objectives, their investment horizon, their risk appetite and their age.”
Investors should spread their capital across a variety of regions, industries and asset classes.