Risk diversification for investments
By choosing a portfolio strategy, investors can significantly reduce the risk associated with investments. A common portfolio strategy is to invest in a variety of assets (i.e. not in a single asset such as the shares of just one company) and to invest in “uncorrelated” assets (i.e. in assets whose performance does not affect the performance of other assets in the portfolio). In other words: Don’t put all your eggs in one basket. This saying vividly sums up the portfolio strategy described above.
For instance, investors who were exclusively invested in shares and real estate during the global financial crisis of 2008 suffered considerable losses due to the banking crisis and the collapse of the real estate market. By contrast, those who were also invested in bonds, commodities or other securities were able to offset, or limit, some of their losses thanks to the relative stability of these types of investment.
(Investment) portfolio
The term portfolio was originally used by artists to refer to a curated collection of their best work. Generally speaking, a portfolio thus describes a collection or compilation of things.
In the financial context, an (investment) portfolio refers to the entire collection of investments held by an individual. Such a portfolio can consist of a variety of assets, including savings, cash, shares, bonds, funds, exchange-traded funds (ETFs), real estate and commodities (see also Securities – shares, bonds and funds, and Investment options – real estate, gold, etc.). By diversifying investments (Diversification) across different asset classes, investors can spread, and thus reduce, risk. They can also tailor their portfolio to match their goals, taking into account personal preferences regarding returns, security, liquidity and sustainability of the investments (for details, see Saving and investing).
Portfolio theory
The portfolio theory looks at how investors can assemble an investment portfolio that minimizes risk and maximizes return. It suggests how investors can strike the right balance between risk and return when building their portfolio, while also accounting for their sustainability preferences. This can be achieved by combining different asset classes whose values tend to move independently of each other.
The basic idea behind the portfolio theory, developed by American economist Harry Markowitz (1927–2023), is that different assets will react differently to the same influences and events. To minimize a portfolio’s risk and maximize its return, investors should allocate their money to different types of securities and assets that perform differently over time rather than in unison. By spreading their investments, investors can thus reduce their portfolio’s risk. So, if one type of investment is performing poorly, other types may be doing well, making up for the losses.
For example, if the value of shares in a company is going down, other types of investment, such as shares in companies from other sectors, bonds or commodities, can help offset, or mitigate, this drop in value. Since most investments do not move in the same direction at the same time, investors can significantly reduce the overall risk of their portfolio and, in particular, the risk of losing all of their money. Had they put all of their capital into one investment, they would not be able to do so.
A brief recap
What do we mean, when we say that we hedge against risk in an investment portfolio?
To hedge against risk in an investment portfolio, investors rely on many different investments that are not correlated with one another. This serves to spread risk, keeping it as low as possible.
How can diversification help reduce the risk of loss in an investment portfolio?
Diversification is the process of investing in different asset classes that usually do not move in the same direction at the same time. This helps investors mitigate the risk of loss in their investment portfolio.
Why is it important that different asset classes in an investment portfolio perform differently over time?
It is important that different asset classes do not move in the same direction at the same time in order to reduce the risk of losing all of the money invested and to enhance the stability of a portfolio.