“What is the best way to invest my money?” – On the path to finding the answer to this question, it is easy to get lost, ask the wrong people for guidance, or draw the wrong conclusions from your own observations.
In a section on the topic of misunderstandings in investing, we would like to address them in detail. Here is part 8: “Dispersion is more useful than you think”.
You can read the previous parts here:
Part 7: Course rockets? Not interesting!
Part 6: Are individual stocks better than ETFs?
Part 5. Sales Slogans Under the Microscope
Part 4: When the decimal places go into thousands of euros.
Part 3: Knowing a lot doesn’t necessarily help much.
Part 2: Investing in cash costs return.
Part 1: MSCI World ETF – just for beginners?
The eggs and the basket
The “don’t put all your eggs in one basket” image is often used when it comes to spreading. This popular wisdom is quickly accepted. However, diversification is far more important and useful in investing than most investors realize. We explain why many experts describe the benefits of diversification as the only “free lunch” available in capital markets. Economists use the “free lunch” as a metaphor for a risk-free profit that shouldn’t actually exist – because you’re given none in capital markets.
Research confirms benefits
Early research showed that although the belief in the superiority of good stock picking was prevalent in the 1960s, highly concentrated portfolios with few stocks were rare – diversification was obviously also important for convinced stock pickers. It was the economist and later Nobel Prize winner Harry Markowitz who first explained mathematically why it is much better to diversify than to just rely on your top three stocks. The tools for this are statistics: volatilities, correlations and covariances. But don’t worry, we’ll explain it in simple words and with examples.
Returns mix proportionally
When it comes to returns, the mix works as you would expect: if you have 100 euros in a stock that yielded 8% and 100 euros in another stock that yielded 3%, then both together have an average return of 5.5%. To calculate this, add 8 and 3 percent, mathematically: (50% x 8 + 50% x 3). If you had held more of the first stocks, for example 75% of your investment, you would have made a return of 6.75% (75% x 8 + 25% x 3). You can always easily calculate the return of your portfolio by multiplying the returns of the individual components by their weight in the portfolio and adding them all up.
This also works with bonds and the same with commodities. Returns are always proportional to the weight of the individual components of the portfolio.
The risk falls disproportionately
When we look at risk, this simple proportionality no longer necessarily applies. Risk in financial instruments is measured as volatility – this is a statistical quantity derived from the standard deviation of the average value of the price movement of an investment. For example, global stock markets have an average long-term volatility of 14. This value in itself cannot be interpreted in a meaningful way, but it helps in comparing with other securities if they have higher or lower volatility.
However, the volatility of two financial instruments does not always match up as one might think: with stocks there can be (very) theoretical cases where each stock has a volatility of, for example, 20, but a suitable combination results in a portfolio volatility of 0. This would be the case of two stocks that always move in opposite directions. No matter how volatile each stock may be, if you find a second stock that always moves in the opposite direction, you can build a risk-free portfolio. In reality, however, there is never such a clear connection.
If 1 plus 1 is less than 2
However, such pronounced correlations are not found in reality, because stocks never all move in sync, but sometimes develop in opposite directions. They depend on industry and country developments and very much on investors’ expectations regarding this particular stock. The risk of a basket of stocks – or an index – will always be lower than the (weighted) sum of the individual risks. Returns are average, but stock risks fall disproportionately when you diversify.
Volatility using the Dax as an example
There are 40 stocks in the DAX whose volatilities over three years (May 31, 2021 to May 31, 2024) are as follows:
- ranges from 12.4 (Beiersdorf) to 56 percent (Zalando),
- half of the stocks have volatility above 27,
- the average of all 40 individual volatilities is 28.7
The DAX with these 40 stocks – in this case not equally weighted – shows a comparatively low volatility of 16.4 over the same period. Thanks to diversification, the DAX has a volatility that is almost as low as the index stocks with the smallest fluctuations.
Only two stocks have lower individual volatility (Beiersdorf and Deutsche Telekom). However, simply holding them is not a good idea because the individual risk of the stocks is very high. This risk is not expressed in volatility; it describes rare extreme events, for example when a company goes bankrupt.
We recently described how to achieve good diversification when comparing portfolios of individual stocks and broadly diversified ETFs: Are individual stocks better than ETFs?
It pays to spread the risk
The benefits of diversification are underestimated because investors may assume that risk and return would be averaged out in a portfolio. This is not the case. Risk falls more than you think. And since the quality of an investment is not measured solely by return, but always by the return-risk ratio, it is clear: the return-risk ratio becomes better if you diversify well, because the risk falls more sharply than the return. This is one of the two options in the capital market to systematically and free of charge improve your risk-return profile. The other option is to reduce costs – we have already explained the importance of this here: When decimals turn into thousands of euros.