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I hope that after reading the title, you are asking yourself “What do eggs and investing have in common?”. And no, I am not going to tell you in this post about options how to buy cheap eggs or only invest in companies that somehow have something to do with eggs. The connection comes from the phrase “Do not put all your eggs in one basket” and diversification.
In this post, we are going to talk more about this concept of spreading your risk, also called Diversification.
We will cover topics such as what is diversification, what are the benefits and disadvantages of it, what types of diversification are there and how should you best implement diversification.
Let’s dig right in.
The General Concept of Diversification
Imagine living in a family where there is only one income earner who provides for the whole family. Let’s say they have an annual income of CHF 80’000. If this person were to lose their job (for example due to a restructuring project or a financial crisis), the family would suddenly not have any income anymore (CHF 0).
Now imagine the same scenario, but this time two people are earning an income of each CHF 40’000 (so CHF 80’000 in total for the whole family). If again one person lost their job, the family’s income would have been reduced from CHF 80’000 to only CHF 40’000. In this case, the family “diversified” their income streams by having two sources of income, instead of one.
In simple words, diversification is the process of reducing your risk, while keep the rewards at the same level, by putt your money in multiple buckets.
Or to use the phrase from above “Not putting your eggs all in one basket”.
The Benefits of Diversification
Let us look at the concept of diversification from an investing point of view. Assume that you have CHF 1’000 to invest and you get a “secret” tip from a friend to invest all of it in company Chocolate AG. Note: all numbers are for illustrative purposes and not based on real figures.
What you can see is that in an individual year, you could have gained as much as 18% in a single year, but also lost 18% in a single year. At the end of four years, you would have ended up with CHF 1240.
Now let us look at the scenario where you invest your original CHF 1’000 in four different companies:
What you want to look at is the total on the right side. In the end, you end up with the same CHF 1’240, but your changes in a single year are much smaller. The maximum you lose in a single year is 2%, however your highest amount is also only 13%.
Think of it in this way: if you have all your money invested with one company, then you can lose all your money if that company goes bankrupt. You could lose everything.
If you invest in four companies, then all four companies would have to go bankrupt for you to lose your entire investment. The chances of this are much smaller than one single company going bankrupt.
The numbers chosen above were picked at random (I promise) and it was a coincidence that in both scenarios the CHF 1’000 turned exactly into CHF 1’240. But the general principle holds:
Diversification reduces your downside risk, while keeping your rewards at the same level.
The Disadvantages of Diversification
Generally, there are two disadvantages of diversification. Number 1, you lose out on big bets.
For example, had you invested all your money with Chocolate AG and it would have grown 30% or more each year, you would have made a buckets of money. But by splitting up your equally in four companies, only 25% of your investment would have profited from this big gain.
On the other hand, had Chocolate AG gone bankrupt, you would have only lost 25% of your initial CHF 1’000.
In essence, if you diversify, then your investment will never perform as well as the best performing company in your portfolio, but it will also never perform as badly as your worst company. It narrows the gap of your possible gains and losses.
Can you pick the right stock? The next big bet?
Well, I consider stock picking to be a game of gambling and based on pure luck. Fidelity analysedtheir customer’s performance from 2003 to 2013 and found that the best performing investors were people who were either dead or had forgotten their investments.
Professional stock pickers, performed worse than dead people over a 10-year period!
Therefore, if professionals cannot identify the next big thing, then you will not be able to do so as well (at least in 99.99999999% of the cases).
The second disadvantage of diversification is that you have to invest in multiple companies and not just one. Every time you buy shares of a specific company you will incur transaction costs.
Meaning, investing in one company generates less transaction costs than investing in four different companies.
This is where index funds come into play. Index funds are an aggregate of multiple companies, sometimes entire markets. Meaning that you can buy a share of an index fund (only one transaction) and own shares in multiple companies.
Therefore, you get the diversification with low transaction costs at the same time.
Correlation and Diversification
There is one more topic we need to talk about before we discuss how to best diversify and that is Correlation.
Imagine having invested all your money in Swiss companies. Your reasoning is that Switzerland is a safe country, with a great economy and a stable political environment. At the same time you want some diversification, so you bought share in the top 20 companies listed on the Swiss Stock Exchange.
Suddenly, the Swiss government announces that the tax rate for Swiss companies will be increase by 10%.
What happens? The shares of all Swiss companies sink, just because more money now goes to the government, rather than the investors.
This means that all companies in your portfolio had a high correlation.
Correlation is a fancy way of determining how similar companies are. Companies with a high correlation are very similar. Companies with low correlation are completely different.
For example, Roche and Novartis are both pharmaceutical companies located in Switzerland. They have a high correlation.
On the other hand, Roche and Facebook have a low correlation, because they operate in different industries (pharma vs technology) and are located in different countries (Switzerland vs USA).
In order for your diversification strategy to work, you need to aim for low correlation between your investments. This way if one segment of your portfolio sinks (for example Switzerland as a whole because they raised taxes), the other will go up or remain stable (Facebook, because it is located in the USA and is not affected by Swiss taxes).
The more dissimilar your investments are, the better diversification works.
Types of Diversification
You can diversify in many ways and I will highlight them below.
When investing, you have multiple asset classes to choose from. Stocks provide a lot of growth, but include quite a bit of volatility as well. Bonds do not grow as much as stocks in the long-run, but their performance is smoother.
Other investment classes would include real estate funds, gold or commodities.
One of the easiest strategies to implement is by investing in companies with different geographies. If you spread your investments over the US, Europe and Emerging markets, you are less likely to be dependent on the economic situation of one area.
If you decide to only invest in one industry, for example pharma, then you are highly dependent on the regulations and performance of that industry. If for example, suddenly patent life-times would be reduced by 5 years, then the value of all pharma companies would sink at the same time.
Another example (although slightly futuristic) would be if you had only invested in car companies. If suddenly a start-up developed a cheap way to teleport people from one place to another, car companies would become obsolete and with it your investment.
How To Implement Diversification
There are no specific rules or best practices around diversification and many different opinions.
Many studies show that you have a great diversification with somewhere around 20-30 companies in your portfolio. The benefit of diversification of above 30 companies is very limited in comparison to increasing your portfolio from 10 to 20 companies.
My approach is the following:
- Invest only in index funds, because they are low-cost and include a large bucket of companies.
- Spread the risk by both by geography and by industry.
Currently (July 2020) my portfolio consists of the following:
- 25% in low cost index fund for Switzerland
- 25% in low cost index fund for EU
- 25% in low cost index fund for Asia
- 25% in low cost index fund for the US
This way I believe that I am diversified across industries and geographies.
Diversification is an interesting topic. Like with everything in investing, there are a ton of opinions out there and no single one is correct.
The only thing that everyone is agreed on, is that diversification brings benefits by reducing your downside and risk.
Choose your asset allocation between bonds, stocks and other assets. Then diversify within those allocations and adjust them once every so often (e.g. every year).
Again, “Do not put your eggs in one basket” is key and will make you sleep better at night.
- Check your portfolio to see how correlated your investments are
- Discuss the topic of diversification with your partner, parents, friends
- Is there another aspect of your life that would profit from diversification, such as building up a second income stream through a side hustle?
What is your take on diversification? What strategies are you following to make sure that your investments are diversified?
Let me know in the comments or send me an e-mail at firstname.lastname@example.org. Any questions, concerns, feedback and constructive criticism is highly appreciated.