Here we first have to ask the question: What is risk? Even professionals still don’t know how to really measure risk, but volatility is the easiest one. Here is the most basic example to begin with: Imagine you invest all your money in one stock, but all of sudden its price falls down by 15%. How would you feel? As you clearly notice putting all your eggs in one basket is rather stupid.
How can you solve this problem? First have to know that risk can be divided into 2 parts: Risk you can diversify away and risk you can’t diversify away. Let’s focus on the first type of risk. How can you diversify away this risk?
First of all, you can spread your money among different asset classes: Stocks, bonds, cash and real estate. The weight of each asset class in your portfolio, of course, is a subjective personal opinion and depends on how risk-averse you are. However, in this form of diversification, it is still possible to invest 25% in one stock, 25% in one bond, 25% in cash and 25% in one building. This doesn’t sound right, does it?
Therefore we have the second level of diversification. This says you should invest in different kinds of stocks and bonds e.g. you buy stocks of BlackRock, ING, Robert Half, EY and some different government bonds. This already sounds a lot better, but imagine we’re back at the end of the nineties and the money we invest in stocks is all invested in tech stocks. In early 2000 we had the dotcom bubble in which a lot of technology firms went bankrupt and most of the technology companies saw a huge decrease in their stock price. This doesn’t sound right, does it?
We arrive at the third level: Invest in companies in different industries with a low correlation. Some of the most important industries are banking, construction, IT, chemistry, energy, telecommunication and car manufacturing. Some of the new upcoming industries are biotech, nanotechnology, eco-industry and renewable energy. But what happens if we invest in all those different industries in Japan and suddenly a nuclear plant in Fukushima explodes? This doesn’t sound right, does it?
This brings us to the fourth level of diversification: International diversification. Not only for stocks, but also for bonds this is something very important. First, we have the 4 big international currencies: dollar, euro, sterling and yen. Depending on your investment strategy it is advisable to hold assets in those different currencies.