How should investors diversify their portfolios
Robin Powell
Prof Martin Weber – University of Mannheim
Hello There! One of the most important lessons we’ve learned from more than 60 years of portfolio construction is that diversifying your investments is a very good idea.
Professor Martin Weber from the University of Mannheim is a recognised international authority on the subject. He says, every portfolio requires a degree of balance:
Diversifying is the key thing to investment. There is a big saying: diversification is the only free lunch you get or you hate risks and you can destroy risk by diversification. That’s the reason it is so important.
The next question is: How do you diversify? The important thing, says Professor Weber, is to diversify across different geographical regions and different asset classes.
The idea of optimally diversifying is that you look at different asset classes first and you diversify across different asset classes and as the second thing, even within these asset classes, you diversify as broad as possible. If you think about different asset classes, clearly as stock, bond and commodities – you can think about other ones – but these are the most liquid tradable asset classes.
Within the stock, you have a variety of different stocks.
Of course, the downside of diversification is that you aren’t heavily exposed to the sector that’s about to enjoy big returns.
But that’s not the point. After all, nobody knows which region or asset class is about to outperform from one year to the next. The beauty of the idea of diversifying is, that you always have some bad things and some good things happening: There might be a bond bubble, there might be a gold rush, there might be a lot of things going on. That is basically the idea of diversifying. If you use a passive diversified strategy, you don’t have to care. It doesn’t matter to you.
Most investors should primarily hold stocks, as well as bonds to dampen the risk. But Professor Weber also recommends keeping a cash reserve, for two reasons.
It’s basically an idea to reduce risk. That’s one reason why you should hold cash in accordance with your risk preference. The second reason is that it is a buffer in case you need some money because your car breaks down, you want to go for a big journey or remodel the house. That’s a different need of cash. So for those two different reasons you might want to hold cash.
So that, in a nutshell, is diversification. It’s not complicated, but it’s very sensible. After all, as an investor, it’s better to be roughly right than completely wrong. Thank you to Professor Weber, and to you for watching. Goodbye.
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