Why diversification is the only free lunch and how you can build a diversified portfolio
Summary: When you build an investment portfolio, it's normal to lean towards investing in what you know best - a few tech names you like or familiar stocks from your home market. But while that might give you a portfolio that feels comfortable, it's far from bullet-proof. Why? Because it lacks one key-element: diversification.
Nobel prize laureate Harry Markowitz famously said that diversification is the only free lunch in investing. What he meant was that while investing, diversification is the only thing you can do, where you are more or less guaranteed to increase your returns without taking on more risk.
Reducing risk in a portfolio is important because it reduces the stress on an investor, and it helps prevent selling investments at the wrong time because of an emotional reaction.
The beauty of diversification is that it is possible to reduce risk whilst maintaining or improving returns, which might explain why it is often referred to as the ‘only free lunch’’
Why you should diversify your portfolio
When you diversify your portfolio, you’re spreading your money across different investments. That means your total investment nest egg isn’t weighted too heavily in any one market or asset class – so, if your favorite tech stock share price suddenly tanks or your home market takes a dramatic downturn, your portfolio as a whole won’t be so vulnerable.
Less risk is just one benefit of diversifying your portfolio. Casting your investing net wider – across the globe if possible – also means you’ll be able to catch more opportunities in financial markets.
Remember the skyrocketing Chinese stock markets in 2014-15? Or the Tesla rally in 2020? By flexing your investing muscles and adding a variety of assets, you’ll not only keep your portfolio more balanced, you’ll also be better placed to find new opportunities around the globe.
Holding a well-diversified portfolio usually also leads to less volatile returns. With only a few investments, your portfolio performance is likely to differ significantly from year to year, while a broader range of investments tends to generate a smoother return development.
How to build a diversified portfolio
Making that initial choice to diversify is the easy bit but identifying what to invest in and the number of investments is slightly trickier.
As a starting point, you should consider holding a mix of various asset classes, such as equities, ETFs, bonds, and commodities. You can diversify further by picking different types of individual investments within your chosen asset class.
One easy way of doing this is to browse different asset classes and filter out investments based on different criteria. At Saxo, you can filter based on geography, industry, bond issuer and market capitalisation.
Another way of building a diversified portfolio is to apply a thematic investment approach, where you start picking a few investment themes, or long-term market trends, you believe in.
At Saxo, you can find a big pool of long-term investment themes, which are handpicked for their future upside potential. The themes range from sustainability to digitalisation and come with inspirational investment lists, with instruments spread out across geographies, industries and company sizes, that give you a well-diversified exposure to the theme you believe in.
If you prefer to “buy the entire theme” over investing in single instruments, you can choose to invest in ETFs, which gives you an instant diversified theme exposure through only one investment.
What is the ideal number of investments?
While there are different opinions about the optimal number of investments in a diversified portfolio, there’s no single correct answer to this question. However, as a rule of thumb, most investors (both retail and professional) hold at least 15-20 instruments in their portfolio.
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