Diversification – The Most Common Mistakes When Spreading Risks

A diversified portfolio is essential for success in investments. Diversification is an investment strategy in which an investor spreads his wealth in varying sums across investments with different risk levels and with differing durations. This reduces risk throughout the entire portfolio, in turn increasing the investor’s chances for returns.

Professional investors often call diversification “the only free lunch in investing” because it requires only a little effort, yet can create considerable added value. However, investors should follow a few basic guidelines when diversifying their portfolios. We list the most common mistakes, which private investors make when diversifying their investments.

Diversification mistake 1: Investing in too few asset classes

One of the most frequent mistakes when diversifying is not spreading investments widely enough. By investing in too few different kinds of asset classes, one risks creating a portfolio dependency on the development of select securities. Exclusively investing in secure assets makes it difficult for investors to generate positive returns in times of low-interest rates. On the other hand, only investing in risky assets with high potential for returns bears the risk of losing the entire sum invested. Therefore, the selection of asset classes has to balance out risks and potential returns. The weighting of portfolio risk is heavily dependent on investor type. Part of the assets should be held as cash reserves in fixed or call money accounts to ensure the necessary liquidity. The remaining free assets should be spread across different asset classes such as precious metals, commodities, bonds, equities, and index funds (ETFs). A small portion can also flow into venture capital in the form of equity crowdfunding, which is considered to be very risky but also offers high return opportunities.

Diversification mistake 2: Only investing in popular markets

Although a solid basic understanding is a good prerequisite for investing, it should not prevent a consideration of international markets and industries. Investors who only invest in markets or sectors which they understand particularly well run the risk of seeing their portfolios lose a great deal of value in the event of a crisis. When spreading the risk of a stock portfolio, for example, it is by no means sufficient to invest in many different shares in the auto industry. The same applies to investments in a single country. German investors, in particular, tend only to invest in German shares, because these are the companies they are familiar with. However, this means they miss out on opportunities in other markets, for example, securities of companies from emerging markets. Although they pose a higher risk than German companies do, they also offer higher earnings opportunities and, above all, are not linked to the development of the German stock exchange.

Diversification mistake 3: Underestimating cluster risks

Too often, private investors ignore the correlation between individual securities in their stock portfolio. The correlation describes the causal relationship between two investments. For equity investments, the correlation expresses the extent to which a change in the price of one security affects the other. For example, an investor could invest in shares of a car manufacturer and in a software company, assuming that the two industries have little in common. However: What if the software company specializes in onboard computers for vehicles and the auto industry is one of its most important customers? Then both shares have a high correlation; if the auto industry experiences a crisis, the tech company suffers as well. There are formulas in financial mathematics to determine the correlation of two investments. Too strong correlations between the securities in a portfolio can lead to so-called cluster risks. As a consequence, the risk-bearing capacity of the portfolio is exceeded and the prices of all securities drop in the event of a crisis.

Diversification mistake 4: Neglecting risk management

One part of risk management is not only the identification of suitable investments but also determining the right amount to invest in these assets. Private investors tend to spread their assets evenly across all investments. When they discover a worthwhile investment, they try to maximize returns by allocating the highest possible wealth to it. The size of a portfolio position should be considered in relation to the potential risk and return on the investment. If one chooses too large a position size, the poor performance of the security can endanger the entire portfolio. There are various methods to determine the correct position size; once again, however, it ultimately depends on the investor type and the investor’s strategy.

Diversification mistake 5: Reallocating securities too often

Private investors tend to reallocate their securities accounts too frequently, especially when investing in equities. This increases transaction costs, which simultaneously lowers the return on the entire portfolio. Every time an investment is traded, financial service providers earn money. This was also the conclusion of a study (Hackethal & Meyer, 2015) commissioned by Finanztest. They analyzed equity portfolios of 40,000 direct bank customers and discovered that these investors had generated around 3 percent less annual return than the market average between 2005 and 2015. The reason was not a lack of financial knowledge, but bad timing when trading. The behavior of investors was partly characterized by high activity: They sold off their securities prematurely when prices fell, thus missing out on long-term price gains. Long-term investment strategies are generally more successful and also prevent having to recalculate the correlations of investments again and again.

What experience have you had with risk diversification so far? Write us a comment!