The importance of diversification — use it like a professional
Why is diversification important?
Diversification is an essential part of professional portfolio management. It’s important to be aware of the risks of each asset class, and investment strategies have to ensure you’re considering a wide range of asset classes. Equities, for example, are riskier than bonds because they fluctuate more. Cryptocurrencies — same issue. However, by having some bonds or cryptocurrencies in your portfolio, you minimize the risk because of diversification. By diversifying your portfolio, you can balance the risks. Investing in different asset classes (e.g., shares, bonds, real assets, and commodities) can help you avoid extreme swings in market returns and maximize your returns.
How to create a diversified portfolio
Create a diversified portfolio by first determining your portfolio’s distribution. A diversified portfolio allocation is based on the number of asset classes you want to invest in and the desired weight of each class. Once you’ve determined your distribution strategy, you can start thinking about the asset classes you want to use. The most common asset classes include stocks, bonds, commodities, and other tangible assets such as luxury watches, high-end spirits, or art.
The portfolio effect of diversification
US economist Harry Markowitz founded the modern portfolio theory (MPT) in the early 1950s. He found that a better balance between risk and return is achieved if you build up your portfolio to spread the risk over several securities and asset classes. He proved diversification reduces the overall risk and minimizes loss. This portfolio effect is possible because the risk of the individual securities cancels each other out to a certain extent since they don’t all develop similarly. For example, let’s say one sector doesn’t perform well on the stock market. The situation can be quite different elsewhere. Avoiding cluster risk is key. The same applies to the development of entire asset classes.
Real assets and alternative investments in your portfolio
Real assets and alternative investments are essential components to support your portfolio’s stability. The risk per investment can be reduced by spreading your portfolio across tangible assets. Tangible assets and alternative investments develop differently than traditional markets, sometimes even oppositely. This leads to a sustainable, positive development of your portfolio without large losses. Think of it like a yin yang.
The practical implementation depends on the investor's personal preferences and risk aversion. However, if you examine the model portfolios of famous fund managers, you can uncover real assets are fixed pillars of the investment strategy. Rob Arnott's model portfolio has the best balance between risk and return, investing 30% in equities, 40% in bonds, and 30% in real assets. So real assets and alternative investments are critical pillars of your portfolio structure.
How to integrate real assets and alternative investments into the portfolio.
There are infinite possibilities. Precious metals such as gold, silver, or platinum are very popular with investors. However, adding luxury items to the tangible assets section is worthwhile to achieve even better diversification. Consider rare wines or spirits, high-quality paintings, as well as luxury handbags, and high-quality watches.
But maybe you’re thinking, “I don’t have 25,000 euros to shell out!” It can also be a lot of money for a small portfolio. At Split Invest, we created a buying syndicate allowing you to stock your portfolio with the most promising tangible assets and alternative investments for as little as 50 euros. Yes, you read that right.
Diversification is a very important strategy in portfolio management to spread risk, minimize exposure and take advantage of return opportunities. To create a diversified portfolio, you must first determine the distribution of your portfolio and then think about several asset classes in which to invest. Weigh your options to achieve the best possible return without increasing their risk.
Learn the five reasons to invest in alternative investments.