The Importance of Diversification

"Don't put all your eggs in one basket." This old adage is possibly the most important and universally accepted piece of investment advice. In the financial world, this is known as diversification.

Diversification is the strategy of investing in a wide variety of assets to reduce risk. The idea is that if one investment performs poorly, the others can offset that loss, thus smoothing out the fluctuations of your overall portfolio.

Why does it work?

The magic of diversification lies in correlation, which measures how two assets move in relation to each other.

• If two assets are highly correlated (e.g., two large banks), they are likely to rise and fall at the same time. Investing in both does not diversify risk much.
• If two assets have low correlation or negative correlation (e.g., stocks and government bonds), the poor performance of one can be offset by the good performance of the other.

By combining assets with different behavioral patterns, the total risk of the portfolio is significantly reduced, often without sacrificing much return potential.

Types of Risk

Diversification helps mitigate unsystematic risk (or diversifiable risk). This is the risk specific to a company or sector (e.g., poor management, a new regulation affecting an industry).

However, it cannot eliminate systematic risk (or market risk). This is the risk inherent to the entire market, such as an economic recession, changes in interest rates, or geopolitical events. All assets are, to some extent, susceptible to this type of risk.

How to diversify?

You can diversify your portfolio in several ways:

• Across Asset Classes: Combining stocks, bonds, commodities, real estate, etc.
• Within an Asset Class:
  • Stocks: Investing in different sectors (technology, health, consumer), countries (USA, Europe, emerging markets), and company sizes (large, medium, small).
  • Bonds: Combining government bonds with corporate ones, and of different durations and credit qualities.

Diversification in this Tool

Our platform is designed around the principle of diversification. By allowing you to select multiple assets and optimize the portfolio, the tool is calculating the historical correlations between them to find the combination that offers the best risk/return profile, making the most of the benefits of diversification.