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“Don’t put all your eggs in one basket”. This statement applies in particular to your investment portfolio. To be more precise, a well-diversified portfolio will optimally protect your capital during bouts of increased uncertainty and volatility in financial markets. This is a very simple rule which, unfortunately, is all too often ignored.
Why is this? Well, putting this rule into practice does require some expertise. Portfolio diversification is determined by three factors. Firstly, there is the weighting of the various positions in the portfolio. This choice is made by the investor or portfolio manager. The following two factors are linked to the characteristics of the various assets, namely volatility and correlations. The first parameter is a measure of the magnitude of return fluctuations and the expected downwards risk. For example, the volatility of European equities will be higher than that of safe German government bonds. In an efficient market, this higher risk will translate into a higher expected return. The second parameter reflects the relationship between the various positions in the portfolio. Here, certain assets typically move in tandem (positive correlation), while an increase in one particular asset may systematically result in a decrease in another asset (negative correlation).
Portfolio diversification can be optimised by combining various assets with the lowest possible, possibly negative, correlation. In this way, the failures will be offset by the successes.
So, given a certain allocation, portfolio risk will depend on volatilities and correlations, which vary over time. For example, when the financial crisis erupted in 2008, stock volatility rose from about 17% pre-crisis to over 60% during the crisis. Today, equity volatility remains low and clearly trends down again since the volatility shock at the end of last year. The correlation between equities and government bonds was typically positive until the end of the 90s, and has gone negative since then.