High Returns at Lower Risks: the Art of Diversification

Diversification in investing means distributing the risk among several smaller investments. It is an investment strategy which aims to minimize the risks associated with individual securities.

You’ve probably heard of a saying that you should never put all your eggs in one basket for if you drop the basket, all the eggs will be lost. However, if you put your eggs into multiple baskets, dropping one will not hurt you that much. You will still have enough eggs left.

Diversification is really just simple mathematics. For example, if you equally divide your investment into the shares of four companies, and three them rise by 20% each while one company goes bankrupt, your investment will yield a loss of -10%.

However, if you spread your investment across a hundred corporations, of which 99 grow by an average of 10% and one company goes bankrupt, your return will be approximately 8.9%. This is what makes diversification so important – it mitigates the risk.

Negative Aspects of Diversification

You could find many different opinions on diversification in the field of investing. It is certainly considered one of the most effective risk-reduction methods. In the past, however, it was often criticized for limiting returns and increasing costs.

This directly relates to one of the greatest investment myths: If you want greater returns, you have to concentrate the investment in a few selected assets with the greatest profit potential. In its essence, this assumption is true, but there’s a catch: it is extremely difficult to execute it in practice.

According to the authors of this statement, the results of diversified portfolios are average, as they reflect the average return of many smaller investments. This deprives the investor of the above-average performance that could be achieved by allocating more money into the potential winners. In other words, broad diversification yields the same returns as the market, which investment managers strive to outperform. They try to achieve that by selecting a few investments that, in their opinion, have the greatest potential to yield larger returns.

In practice, however, fulfilling this objective usually remains mere wishful thinking. The vast majority of managers fail to even achieve market returns. The main reason for the underperformance of their portfolios is that asset prices cannot be accurately predicted. Such concentrated portfolios thus result in lower returns with significantly higher risk exposure.

Similarly, in the past, broad diversification has been associated with higher costs, as it required a larger number of transactions, each being subjected to fees.

However, with the arrival and popularization of ETFs, this drawback of risk-spreading has also been eliminated. These index funds have enabled investors to purchase thousands of securities with only a few transactions. Hence, they made it possible to eliminate the individual risks of issuers at a very low cost.

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Why Does Diversification Work?

A common error made by novice investors is attempting to only invest in winners. Typically, they try to identify stocks or mutual funds with the highest growth potential, often relying on past performance as the primary guiding factor.

Among small investors, the prevailing strategy involves perusing lists of mutual funds and choosing the one with the best historical appreciation. This approach is fueled by the erroneous assumption that current growth trends will persist into the future.

Examining the trajectory of Tesla's stock prices from 2020 until the close of 2021 alongside the performance of the US S&P 500 stock index (which is a proxy for the development of the wider market) during the same period provides valuable insights.

During this period, Tesla stood out as a dominant performer, significantly benefiting its investors and users. With revenues reaching nearly 53.8 billion U.S. dollars in the 2021 fiscal year, its stock achieved an unbelievable four-digit return over our observed period, a truly exceptional result. There seemed to be no indication of a deviation from this upward trajectory.

Source: TradingView

If an investor had to make a choice between investing in Tesla shares or the broader market represented by the S&P 500 based on the provided graph and the prevailing market sentiment, they would likely have favored Tesla's shares at the onset of 2022. For many investors, Tesla was one of the automatic first choices when selecting stocks for their portfolios at this time.

Over the subsequent two years, they would’ve encountered all the inherent risks associated with picking individual stocks. While an investment in Tesla stock has lost nearly half of its value since the beginning of 2022, the S&P 500 index, which represents a diverse array of the largest U.S. companies, has recovered from the downturn and is already in double-digit gains.

Source: TradingView

It is also interesting to look at the psychological game played by these two investments within the examined period. Standing at the beginning of 2023, many investors might have considered the updated data and conclude that times were too dangerous to invest in volatile tech stocks like Tesla, especially with the potential threat of new competition in the EV sphere from foreign countries (such as China). This might have lead many to sell these stocks and increase their exposure towards the index.

However, over the course of 2023, Tesla shares doubled in value, surpassing the S&P 500 index, which achieved only a 24 % gain during the same period. And that was again not a good reason to sell the index for Tesla at the beginning of 2024, as the company subsequently missed its earnings call (quickly losing a quarter of its market value), while the S&P 500 kept growing since January.

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

The principle of diversification extends its influence not only across individual assets but also within economic sectors and geographic regions. This holds true especially for extended investment horizons, which form an essential foundation for successful investing. It underscores the challenge of accurately predicting the long-term trajectory of traded assets.

For example, investors currently prefer U.S. stocks because of their performance in the past decade. Sectors like technology, biotechnology, and healthcare are in vogue. But will they remain at the top of performance rankings over the upcoming decade and were they also dominating 20 years ago? Do you think investors will be able to correctly predict 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. It covers the 10-year period until the end of 2017. The chart accurately depicts why U.S. stocks are the most popular today. They have recently brought the highest profits.

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 trend of their relative performance has completely reversed over the last two decades.

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

This even led to the emergence of the investment class called BRIC (Brazil, Russia, India and China), created by a well-known economist of Goldman Sachs. BRIC was everywhere and BRIC was the future. The funds focused on BRIC assets recorded the largest capital inflows.

In the end, however, they disappointed the investors. Stocks of emerging markets achieved the worst performance among our asset classes in the past decade. On the other hand, the U.S. stocks that lagged behind between 1997 and 2007 dominate today.

Let's delve into another illustrative example that captures the shifts in dominance between the MSCI EAFE (international stocks from Europe, Australasia, Far East) and S&P 500 indices over the past five decades. To understand the discrepancy between U.S. and international performance, we will first look at their sector composition. Over the last decade, the U.S. has enjoyed a positive influence due to its substantial allocations in the top-performing technology, consumer discretionary, and health care sectors. Conversely, the international landscape has faced challenges, primarily stemming from higher weightings in financials and industrials.

The U.S. has further reaped the rewards of robust fundamentals, particularly in the post-global financial crisis (GFC) era. Earnings of their companies grew remarkably, although they were concentrated in a few companies. The U.S. and Japan were the only major economic blocs where profit margins increased after the GFC.

However, there is no guarantee this domination will last forever. For instance, one can make a compelling case for considering international equities, especially if inflation exhibits resilience and enduring secular themes like infrastructure development, automation, defense spending, and renewable energy continue to unfold.

This is not to say it has to occur in the coming years, I’m definitely not recommending you sell all U.S. stocks and concentrate heavily on international markets. My aim is to highlight that a single region will not necessarily continue to dominate forever just because it offered superior performance over the past couple of years. Anything can happen in the global economy.

A historical analysis, depicted graphically, illustrates the ebb and flow of the two regions discussed above, showcasing their alternating and complementary performances over the decades. While the S&P 500 has outperformed the MSCI EAFE index in the past two decades, you can see that in the period before the late 1990s, it was more common for EAFE stocks to outperform the U.S. The two indices switched the leadership role many times over the observed 50 years.

This uncertainty underscores the importance of diversification in investment strategies. Instead of relying on a single winner, a prudent approach involves spreading investments across the entire market. This mitigates the risk of missing out on potential gains if stocks outside of the U.S. experience a resurgence. Diversification ensures a well-positioned portfolio, capable of benefiting from the diverse performances of various sectors, providing a balanced and resilient investment strategy.

Source: T. Rowe Price

The importance of diversification is also clearly depicted in our favorite "periodic revenue table" inspired by the Callan company. Although it may appear complicated at first glance, it offers an easily readable overview of the development of asset classes in each particular year.

Finax chart consists of the performance of the 10 ETFs included in the Intelligent investing portfolios. Each column of the table represents one year, with the asset classes being ranked by their achieved return from the top to the bottom. Classes with the highest one-year return are at the top, those which lagged behind are at the bottom. Each asset class always has the same color.

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, successful periods are followed by years of lagging performance. No color occupies the top spot for an extended period.

Let's look at an example. If you consistently invested in the fund with the best performance during the previous year, you could expect an average annual appreciation of 8,1 %. If you were to spread your investment equally between the previous year’s two best funds, your average return would decline to 6,9 % per year.

In contrast, employing a diversified approach, such as spreading your investment across the 100 % Finax equity portfolio with automated regular rebalancing, your annual return would increase to nearly 9,8 % (cumulative 268 %) over the same period. These examples illustrate the advantages of diversification in optimizing returns.

It's crucial to recognize the limitation of relying solely on past performance. Historical data offers limited insights into future developments, and forecasting future market movements with confidence remains a challenge for most investors and fund managers.

Therefore, diversification serves a dual purpose. Beyond risk mitigation, it functions as a tool for enhancing and stabilizing long-term returns. Its significance lies not only in minimizing risk but also in achieving a favorable ratio between appreciation and risk. This, ultimately, forms the bedrock of a successful investment strategy.

What Is Diversification?

Simply said, diversification is spreading the risk across several smaller investments. Risk should not be concentrated in well-designed portfolios, with the exposure to individual securities being low.

Diversification almost completely eliminates risks associated with particular companies or issuers, sectors or countries (the so-called non-systemic risk). The only type of risk that remains is called the market risk, which can be further eliminated by setting a proper investment horizon.

Diversification becomes more efficient if one creates a portfolio using 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 a 1% growth of Meta shares tends to be accompanied by a 0.5% increase of the S&P 500 index (on average), the assets have a positive correlation with coefficient of 0.5. Now imagine that government bonds typically move in the opposite direction to Meta shares. For instance, a 1% growth of Facebook shares can typically coincide with a 0.2% fall of government bond prices. This is a negative correlation with a coefficient of -0.2. In this case, diversification would be more efficient at reducing risk.

If you invest in multiple assets that develop differently (that is, some increase as others decline or they exhibit different degree of fluctuation), the overall volatility of the portfolio value is lower, leading to a reduction of losses and the overall risk.

What Diversification Does Finax Offer?

Diversification played a crucial role in the creation of our portfolios. The goal was simple, to introduce a universal strategy suitable for every period. We wanted Intelligent Investing to be an excellent product not only today, but also 10 years in the future or 10 years in the past.

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 avoid predicting the future development of asset classes. We consider this approach as counterproductive, for it does not achieve higher returns in the long run, 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 by copying the composition of indices. Sufficient diversification is the foundation of successful passive investing.

Finax proudly offers portfolios that are among the most widely diversified options on the market. For as little as 10 euros, you can get around 13,400 securities - 7,400 shares and 6,000 bonds.

With Finax, you can rest assured that your portfolio always contains businesses that are currently doing great, as well as those whose time to shine will come in the future. Some exclusive benefits include:

• Diversification across the main financial asset classes (various stocks and bonds), ensuring a lower market risk;
• Currency and interest rate diversification - assets in our portfolios are denominated in various currencies, ranging from the Euro and the Dollar to exotic currencies of emerging markets;
• Regional diversification - Finax invests in securities from more than 92 countries all over the world;
• Sector diversification - the portfolios consist of 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 - our portfolios contain more stable dividend companies, cheap value stocks, and expanding growth stocks.

Whatever comes to your mind when you think about investing is included in our portfolios. Regardless of what happens to the markets and economies in the future, a 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 strategy. 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, it is the optimal solution.

If you are already investing via a different financial product and you aren't sure whether it has a suitable risk and return profile, or if you are dissatisfied with the achieved returns, send us your investments for evaluation.

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