Diversification - how to earn more with lower risk

Diversification is key to passive investing. It is also a great and simple tool that reduces the risk of investment and enables long-term stable return. Finax offers portfolios with the highest degree of diversification in the Slovak market. How does diversification work, what does it stand for and why is it important to your investment?

Radoslav Kasík | Our process | 9. May 2019

Diversification is the distribution of risk among several smaller investments. It is considered to be an investment strategy with the goal of minimizing the risks associated with the particular security.

You must have heard the advice that you should not put all your eggs in one basket. When you drop the basket, you will lose all the eggs with it. However, if you divide your eggs into multiple baskets, losing one will not hurt you so much. You still have enough eggs left.

Diversification works like basic mathematics. For example, if you equally divide your investment portfolio into the shares of four companies and three of them earn you 20% each, but one company goes bankrupt, your investment will result in a loss of -10%.

However, if you split your investment among a hundred corporations, of which 99 grow on average by 10% and one company goes bankrupt, you will earn approximately 8.9%. This is the role of diversification - risk spreading.

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Negative aspects of diversification

There are different opinions on diversification in the investment world. In terms of risk, it is certainly one of the most effective methods of risk reduction. However, in the past, it has been criticized for its achieved revenue or higher costs.

One of the investment myths is that if you want to earn more, you have to concentrate the investment on the selected assets, with the greatest profit potential. In essence, is this assumption true, but the catch lies in its realization.

According to the authors of this statement, the results of the diversified portfolio are in average achieving only the average return of a number of small investments, which deprives the investor of the performance of potential winners. Broad diversification achieves practically market returns that investment managers want to outperform with their results, so they choose only a few of the, based on their opinion, most potential investments.

In practice however, achieving this objective, that is to say, the choice of market-beating securities, remains only as a wishful thinking. The vast majority of managers fail to achieve even market returns. The main reason for the underperformance of the portfolios is that assets prices cannot be accurately predicted. Concentrated portfolios ultimately result in lower returns with significantly higher risk exposure.

Similarly, in the past, high risk spreading has been associated with higher costs. Buying a large number of titles requires a number of transactions, and each transaction is subjected to fees.

With the arrival and popularization of ETFs this drawback of risk spreading has also been eliminated. Indeed, the index funds with broad portfolios have made it possible to invest in a large number of securities, at very low cost, and thus eliminate the individual risks of issuers.

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Why does diversification work?

The basic mistake of beginning investors is that they only try to invest in winners. At best, they look, using all kinds of investment approaches, for stocks or mutual funds that could grow the most, but this search is usually driven by past performance.

The most common investment strategy for small investors is to look at the list of mutual funds and select the fund with the highest past appreciation. Or follow the incorrect expectation that what is growing today will also grow in the future.

The following chart shows the development of Facebook stock prices since its stock market entry in May 2012 until the end of 2017 and the development of the US S&P 500 stock index over the same period.

At that time, Facebook was a dominant social network that managed to make a good fortune out of its broad reach of nearly two billion users, thanks to its clever advertising approach. The year-on-year growth in profits fluctuated in high double-digit percentages and there was no reason to expect a change in the established trend.

If a potential investor were to decide, between these two options, where to put their money, based on the graph and general market sentiment, they would have most likely opted for Facebook shares at the beginning of 2018.

In the following year, they would have experienced all of the risks associated with individual share. The number of Facebook users had stagnated, the average time spent on the platform had fallen and the share price had plummeted because of the data leak scandal.

As a result of largely unforeseen events, the Facebook investment lost nearly a third of its value in one year, while the broad index of the largest US companies only lost 8%.

It can be further assumed that, based on new information from 2018, most of the investors would prefer to invest in the index, because Facebook lost its appeal at that time. However, profit from Facebook shares exceeds 45% since the beginning of this year. In the meantime, the S&P 500 index achieved only 15%.

In the history of financial markets, we would have found thousands of examples similar to Facebook case. A concentrated bet on just one or a few titles always carries higher risks.

The effect of diversification can also be demonstrated in the economic sectors themselves, when investing in the individual regions. This is also the case for longer investment horizons, which are a precondition for a successful investment. In this regard, the inability to accurately predict the long-term development of traded assets comes to the fore.

For example, investors currently prefer US stocks because of their performance in the past decade. Technology, biotechnology and healthcare firms are chosen among the sectors, as they are currently considered trendy. But will they also be the most successful one in the upcoming years and were they 20 years ago? Do you think investors will be able to forecast the change in this trend?

The following chart shows the development of 6 indices, which form the basis of the equity component of the Intelligent Investing portfolios, over the 10 years until the end of 2017. The chart accurately depicts why US stocks are most popular today. They are currently the most profitable.

However, once we have a look at these asset classes a decade earlier, that is, their evolution from early 1998 to late 2007, we will find different winners. The assets completely reversed within two decades.

The period before the financial crisis was dominated by stocks from developing countries. At a time when Finax's founders started in the financial sector, 15 years ago, everyone loved and invested only in the emerging markets.

This even led to the creation of investment class BRIC (Brazil, Russia, India and China), created by the then-known economist of Goldman Sachs. BRIC was everywhere and BRIC was the future. The funds where focused on the assets from the BRIC countries and they recorded the largest capital inflows.

In the end, however, they disappointed the investors. Stocks of developing countries achieved the worst performance in the past decade. On the other hand, the US stocks that lagged behind between 1997 and 2007 dominate today.

The importance of diversification is clearly depicted in our favorite so-called periodic revenue table inspired by the Callan company. At first glance complicated table offers an easily readable overview of the development of asset classes in the particular year.

Finax chart consists of the performance of the 10 ETFs, on which the Intelligent Investing portfolios are built. Each column of the table represents one year, and each asset class, always marked with the same color, is ranked in columns by the yield achieved in that year from highest to lowest.

The goal of the periodic table is to show that the colors at the top and bottom of the columns alternate. For each asset class, the successful period is followed by years of lagging performance. No color occupies the top spot of the yield ladder over a long period.

If you invest at the beginning of each year in the fund that achieved the highest yield in the previous year, you would on average appreciate your money by only 1.1% per year (less than 17% over 14 years).

However, if you spread your investment equally between the two best funds of the previous year, your average annual yield will rise to 4% (cumulative 74% over 14 years).

By diluting the investment in the 100% Finax equity portfolio with automated regular rebalancing, you would achieve an appreciation of nearly 7% per annum during this period. These examples clearly reveal the benefits of diversification.

The main problem of the above-mentioned investment approaches is looking into the past, which contains little information about the future development. Very few investors or managers can look ahead with sufficient confidence and anticipate price developments.

It is therefore clear that the purpose of diversification is not only to minimize risk, but can also be described as a tool for increasing and stabilizing long-term returns. Its more important role is to achieve a very favorable, high ratio between the achieved appreciation and the risk taken, which is the foundation of a successful investment.

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What is diversification?

The fundamental of diversification is simply spreading the risk among several smaller investments. In case of a well composed portfolio, the risk is not concentrated. The exposure to individual securities is low.

Diversification almost completely eliminates the risk associated with a particular company or issuer, sector or country from the portfolio, the so-called non-systemic risk. Only the market risk remains, which can be nullified with proper investment horizon.

Diversification is more effective when building a portfolio using the securities with lower or negative correlation. Correlation is a relationship or association in the development of two assets. It is expressed by the correlation coefficient.

For example, if an average 1% growth of Facebook shares is accompanied by a 0.5% increase of the S&P 500 index, the assets have a positive correlation with coefficient of 0.5. But government bonds, in case of 1% growth of Facebook shares, fall by 0.2%. This is a negative correlation with a coefficient of -0.2. In this case, diversification would be more effective in reducing risk.

If you invest in multiple assets that develop differently, i.e. some increase as others decline or their fluctuation are not the same, the overall volatility of the portfolio value is lower. The losses and the overall risk of the investment are lower.

What diversification does Finax offer?

Spreading of the risk played an important role in Finax portfolio creation. Our goal was to bring to market a universal strategy suitable for every period. We wanted Intelligent Investing to be an excellent product not only today and 10 years later, but to also be suitable for most investors 10 years ago.

We have refused to manage the portfolios in an active way; we do not want to reflect current trends or the market situation and we do not want to predict the development of asset classes. We consider this approach as counterproductive, as it does not achieve higher returns in the long term, as confirmed by numerous studies and also by the results of investment solutions themselves.

We consider passive investing to be the most appropriate investment approach in terms of returns and risks. Passive investing offers market returns, which are achieved by copying the composition of indices. The condition for successful passive investing is sufficient diversification.

In Slovakia, you will currently not find a more diversified portfolio than the one offered by Finax, that is to say with this level of risk spreading or with a better return to risk ratio. From as little as 20 euros, you can buy with our convenient solution around 9,500 securities (5,500 shares and 4,000 bonds).

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With Finax, you can be certain that you are always investing in a business that is doing well and in assets that will grow in the future. Only with Finax you get:

  • Diversification across the main financial asset classes (various stocks and bonds), that ensures lower market risk;
  • Currency and interest rate diversification - you invest in assets that are denominated in various currencies ranging from euro, through dollar to exotic currencies of developing countries;
  • Regional diversification - Finax invests in securities from more than 90 countries located all over the world;
  • Sector diversification - in the portfolios you will find shares representing all sectors of the economy, as well as government securities;
  • Size diversification - with one portfolio you acquire shares of small promising companies as well as large established multinational corporations;
  • Diversification of investment approaches - you acquire more stable dividend companies, cheap value stocks and expanding growth stocks.

Whatever you think of when investing, you have in Finax's portfolios. Whatever happens to the markets and economies in the future, you can be sure that certain part of your portfolio will benefit from it.

The passive approach of Intelligent Investing is the foundation of any successful investment portfolio or wealth building. Unless you want to speculate or have specific investment goal in mind, you essentially don't need another type of investment in your life. In terms of risk, this is the optimal solution.

If you are already investing using another financial product, but you are not sure about the risk and the corresponding return, or you are not satisfied with the achieved earnings, send us your investments for reconsideration.

If you move your underperforming investments to Finax, we will grant you a discount on the portfolio management fee. The Intelligent Investing will there be even more effective.

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