What does diversification mean?
When people talk about diversification, they are basically talking about spreading investment risks across different building blocks. When private investors diversify their portfolios, they spread their assets not only across one asset class, but across several asset classes, regions and sectors.
The underlying logic is quickly explained: each asset class develops differently. Part of the portfolio risk is represented by the so-called market risk (or systematic risk). This refers to changes that influence the entire market - for example, a financial crisis, a global pandemic or adjustments to interest rate policy on the part of central banks. These risks cannot be eliminated or reduced through diversification.
What risks can a private investor influence? The company-specific risks. These include factors related to a specific company. Management, competitors, disruption or IT failures - everything can influence the market value of a single company. If you invest in just one company, you tie up all your capital in market risk and company-specific risk. If you invest in 100 companies (from different sectors), you are still subject to market risk - but the company-specific risk has been spread over 100 companies and is thus reduced.
To understand the meaning of diversification, we often use an analogy with Netflix: Suppose you could only stream dramas or animated films on Netflix from now on. Would you cancel your subscription? In this case, the probability is much higher than if Netflix focuses on a wide range of genres. Then you would have a lot more choice when streaming and Netflix would appeal to a larger target group. The financial risk decreases through diversification, because subscriptions mean revenue for the company. The situation is similar with investments. Diversification can (but doesn't have to!) have a positive effect on your portfolio risk.
The concept gained importance through the US economist Harry Markowitz. In the course of his research, he recognised that investors can reduce their portfolio risk - while maintaining the same return - by adding further asset classes. For this insight, he was awarded the Alfred Nobel Memorial Prize for Economics in 1990.
How does diversification work?
We have already touched on the basics in the first section, but here comes another detailed explanation of how diversification works. We distinguish here between vertical and horizontal diversification. Horizontal means that an investor invests in different asset classes. In this case, the portfolio structure could look like this:
- 10.000€ in shares
- 10.000€ Government bonds
- 10.000€ in real estate
- 10.000€ in Private Equity
- €2,500 in cryptocurrencies
Vertical means that diversification takes place within an asset class. Here, an exemplary asset allocation could look as follows:
- 5.000€ in shares Europe
- 2.500€ in shares USA
- 2,500€ in Asia shares
Because assets within an asset class are highly correlated, horizontal diversification is far more effective in managing risk. For example, the correlation between high credit quality government bonds and equities is inherently lower than between equities - regardless of their regional affiliation.
Correlation means the statistical relationship between two or more values. The lower the correlation, the better it is for risk diversification. An asset class that develops in the opposite direction (negative correlation) to another can offset or cushion losses.
Example: Portfolio diversification in practice (2022)
Historically, PE investors have achieved returns that have outperformed the global equity market. In return, investors have to accept that their invested capital is tied up for a certain period of time. A typical fund has a term of about ten to twelve years. Those who withdraw their capital earlier must reckon with high markdowns that reduce a large part of the return. What seems disadvantageous at first can turn out to be a significant advantage. A long holding period reduces the risk of loss when investing money.
Here'san example: according to an analysis of the return distribution of the MSCI World, which summarises the performance of the 1,600 largest companies (by market capitalisation) from 23 industrialised countries, investors who have invested since its inception in the 1970s have always achieved a positive return if they have been invested for at least 15 years . The longer the investment horizon, the lower the probability of loss.
With private equity, investors are not subject to the risk of reacting impulsively to strong market fluctuations and constantly adjusting their portfolios. In the traditional capital market, only brokers profit from this back-and-forth, because they collect fees for every transaction their clients carry out.
Private equity can also be a valuable building block in the portfolio by providing the retail investor with another opportunity for diversification due to the reduced correlation of PE to the public market (stock exchange). Due to the active role of PE companies in their investee companies, crises are more likely to be better managed. In an emergency, companies receive additional financial and strategic support in crisis phases. Of course, this does not apply to every PE company.
Important note: However, investors must also be aware of the risks of private equity. Often it only becomes apparent after an investment that a business model is not viable. Depending on the weighting in the fund, such a case can significantly reduce the total return or lead to a total loss. PE funds try to avoid such cluster risks through broad diversification. However, default risk can never be eliminated. Nor is the high capital commitment always advantageous, since investors are exposed to the arbitrariness of the PE managers in this case. Not all decisions serve the long-term good of an investment. Employee layoffs are among the measures often taken to save costs in the short term. Expansions are also often initiated at a stage that does not suit the company. If companies fail as a result of these strategies, investors do not have the chance to withdraw their capital early.
A large proportion of the companies into which equity capital flows fail after a few years. This reduces the return of the funds and can lead to severe capital losses if the failures cannot be compensated by corresponding profits. Due to their passive role, investors have only limited possibilities to receive their invested money prematurely. Normally, an early withdrawal is associated with high markdowns (and thus a guaranteed loss).
Does broad risk diversification increase returns?
It is about time that we substantiate the knowledge we have just acquired with real data. The graph below shows that a pure equity portfolio has a much weaker risk-return ratio than an equity portfolio to which private equity has been added. The expected return has increased while the risk level has remained the same.
Don't get us wrong here: there is a correlation (statistical relationship between different asset classes) between alternative investments and traditional capital markets. However, this is (on average) much lower than the correlation within listed assets. The higher the correlation, the more strongly different assets move in the same direction. For this reason, private investors generally look for asset classes that have only a low - or even negative - correlation. In this way they reduce their portfolio risk. The decisive advantage of PE arises, among other things, from the long holding periods. Read more about the advantages in our article on private equity as an asset class.
Risk profile must be defined prior to asset allocation
It is possible, for example, if an above-average return is achieved with the mixed asset class - on the other hand, a higher expected return also increases the risk of loss. In principle, the goal of diversification is not a higher return, but a minimisation of risk while maintaining the same return.
Broad risk diversification has considerable psychological advantages. If diversification succeeds in reducing the range of fluctuation, the stress level of many investors decreases if there is turbulence on the stock markets. Where is the danger in such phases? The greater the volatility (price fluctuation) of prices, the more likely it is that private investors will get into a mental state in which they hastily dispose of their investments for fear of high losses. Many turn their backs on the stock markets permanently after such events. In the past decades, global shares (MSCI World Index) have always recovered from times of crisis (see chart below). Those with staying power have benefited from solid returns to this day.
Here is an example: The MSCI World Index marked a new record high of 322 US dollars on 14 February 2020. In the course of the pandemic, the price plummeted by almost 25%. Since the low of 243 US dollars on 20.03.2020, the price has risen by +128% to 554 US dollars (as of 02/22) - those who have exited the market have denied their capital a major growth spurt. Diversification can save private investors from overreactions if they have large cluster risks in their portfolio that lead to strong movements in certain stock market weather.
It becomes problematic if a price collapse occurs when the capital is needed (e.g. for retirement). Since this risk is real, private investors should always hold sufficient liquid assets to cover their financial needs even in difficult phases (without selling their assets).
In contrast, private equity investors are "practically forced" into a long commitment period. Their returns only come after a long holding period, during which fund managers try to increase the value of their holdings. Selling one's own shares is possible only rarely and at high discounts. This supposed "disadvantage" can also be to the advantage of investors if they are virtually "forced" to stay on the ball.
Even with private equity, there are default risks which, in the worst case, can lead to the total loss of the capital invested. Companies can prove to be unsustainable after an investment, PE managers can make serious mistakes and the general market situation can also change abruptly (e.g. due to regulation or competition).
Times have changed for private investors
20 years ago, diversification was much more difficult to implement in practice. While private investors today can invest indirectly in (almost) every asset class via ETFs or digital tokens, this was not the case 20 years ago. Anyone who wanted to invest in real estate had to come up with high entry sums. The situation is similar with the art market or the market for luxury goods (e.g. fashion, watches and other jewellery).
For a long time, private equity was also an asset class in which - especially small investors - could not invest directly (but only via ETFs on the PE market). Institutional investors, on the other hand, have been using PE for decades to allocate their assets and have achieved high returns on their investments to date. We at tokenstreet are planning to change this situation with digital access to venture capital and private equity funds via app. In future, private investors will be able to invest indirectly in private equity for as little as €100.
As a further component in the portfolio, private equity can improve the risk profile by providing an additional pillar for asset development. Compared to traditional stock markets, PE has historically proven to be extremely crisis-resistant. Nevertheless, PE is also subject to investment risks. Investments can prove to be unsustainable after an investment and reduce the return of the PE fund. Total losses can never be ruled out despite the advantages mentioned above.
Important note: Investors need to be aware of the risks of private equity. Often it only becomes apparent after an investment that a business model is not viable. Depending on the weighting in the fund, such a case can significantly reduce the total return. PE funds try to avoid such cluster risks through broad diversification. However, default risk can never be eliminated.
A large proportion of the companies into which equity capital flows fail after a few years. This reduces the return of the funds and can lead to severe capital losses if the failures cannot be compensated by corresponding profits. Due to their passive role, investors have only limited possibilities to receive their invested money prematurely. Normally, an early withdrawal is associated with high markdowns (and thus a guaranteed loss).
