How do I diversify my portfolio?

Why diversifying your investments is a very good idea

Why is diversifying your investments such a good idea, and how do you do it well? One of the most important lessons from more than 60 years of portfolio construction is beautifully simple: spreading your investments is one of the smartest things you can do. Diversification has even been called "the only free lunch you get" in investing, a way to reduce risk without sacrificing your expected returns.

In this video, Professor Martin Weber of the University of Mannheim, an internationally recognised authority on the subject, explains why diversification is the key to successful investing and how to go about it. He argues that every portfolio needs balance, and that the core idea is to reduce risk by not concentrating your money in any one place. If you hate risk, he explains, diversification is the tool that lets you destroy a good deal of it.

You'll learn how to diversify properly. The important thing, says Professor Weber, is to spread your money across different asset classes first, such as stocks, bonds and commodities, the most liquid, tradable options, and then to diversify as broadly as possible within each of them, holding a wide variety of stocks rather than a concentrated few. The trade-off, of course, is that you'll never be heavily exposed to whichever single sector is about to soar. But that's precisely the point: nobody knows which region or asset class will outperform from one year to the next. With a passive, diversified strategy, you don't have to care, because you'll always hold some of whatever is doing well.

The video also explains why most investors should primarily hold stocks, with bonds to dampen the risk, and why Professor Weber recommends keeping a cash reserve too. Cash serves two purposes: it further reduces risk in line with your personal risk preference, and it acts as a practical buffer for life's unexpected needs, whether the car breaks down, you want to take a big trip, or you decide to remodel the house.

The takeaway: diversification isn't complicated, but it's extremely sensible. By spreading your investments across and within asset classes, adding bonds to smooth the ride and holding a sensible cash reserve, you put yourself in a far stronger position. As Professor Weber puts it, as an investor it's better to be roughly right than completely wrong.

Chapters / Key points

• Why diversification is one of investing's most important lessons
• Why it's been called "the only free lunch" in investing
• Why every portfolio needs balance
• How to diversify across different asset classes
• Why you should also diversify broadly within each asset class
• Why missing out on the top sector is the point, not a flaw
• Why a passive, diversified strategy means you don't have to guess
• Why most investors should hold mainly stocks, plus bonds
• The two reasons to keep a cash reserve

Transcript

How do I diversify my portfolio?

Robin Powell: 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.

Martin Weber: 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.

Robin Powell: 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.

Martin Weber: 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 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.

Robin Powell: 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.

Martin Weber: 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.

Robin Powell: 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.

Martin Weber: 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 for cash. So for those two different reasons you might want to hold cash.

Robin Powell: 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.