One of the most frequently cited doctrines in the investment world is the basic rule of diversification—the distribution of invested assets across different securities and asset classes. That said, there are two completely different opinions on this subject. While one group of investors says that you should not put all your eggs in the same basket in order to avoid large losses, others say that an investor must put all eggs in one basket in order to maximize returns. However, the investor using the latter strategy needs to pay very close attention to his portfolio at all times since a so-called high conviction investment strategy is also associated with considerable risks. Nevertheless, it is certainly true that an investor who spreads his investments across various assets cannot achieve the maximum return since only one asset/security can achieve the highest return.
Conversely, diversification is seen as the first line of defense for a portfolio. Diversification is achieved by combining securities from different asset types (bonds, commodities, equities, money market, and precious metals) within a portfolio. There are literally two different ways to build a diversified portfolio. One is the so-called naïve diversification, which is the result of simply buying assets/securities from different asset types. The other one is buying assets from the same or different asset type based on the evaluation of their correlations to each other and their respective risk contribution. The acceptable level of risk of the individual portfolio components is determined by the investor’s risk appetite.
Although the risks of the securities markets cannot be completely ruled out by diversification, investors can reduce these risks by implementing such a strategy. The ultimate goal of diversification is to minimize the volatility of a portfolio and, therefore, protect the capital of an investor during market drawdowns. After all, the preservation of capital is the decisive criterion for capital accumulation because anyone who has lost half of their assets must then double their capital to get back to where they started.
Another reason to diversify a portfolio can be seen in the fact that the investor can cover capital requirements in negative market phases by withdrawing cash or selling assets that still have performed well instead of realizing losses.
However, the market turmoil over the course of 2022 showed that even broadly diversified portfolios cannot always protect the investor against price losses. Over the course of 2022 equities, bonds, and commodities faced losses when the Federal Reserve and other central banks around the globe started their quantitative tightening cycle and increased the interest rates in several steps. As a result of these actions, even broad diversified 60/40 strategies showed massive losses at the end of year. Nevertheless, broad diversified portfolios might have lost less than their more concentrated peers.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.
