Diversifikatiion

Diversification for minimizing the risk in Portfolios

It was in the year 1952, when in the „Journal oF Finance“ the article "Portfolio Selection" was published of Harry M. Markowitz. The article dedicated itself to the thought, at that time for the first time to place by mathematical computations individual securities to Portfolios together in order to minimize thereby the risk.

It took however still long years, until this theory could begin their triumphant advance. Only in the year 1990, when Harry M. Markowitz as well as its pupils William Sharpe and Merton Miller had received the Nobel award for economic science, the portfoliotheorie the break-through succeeded.

But which are the most important realizations from its work:

The risk from different investmens is ever smaller or maximum equal to the relatively weighted risk, which the individual investments regarded alone.
One invests in a country or in parallel investment objects, no minimizing the risk is reached.
Naive, thus unmethodical diversification is better than no diversification, but can via it no real investment optimization take place
One achieves the largest potential of the diversification, if the yields of the different investments are diverging

But how the risk estimate of an investment actually develops?

Today the definition applies: The risk is as standard deviation (variance) the measured range of yields around its expectancy value. That means it, that an investment, whose possible results vary only little, is more risk-free than an investment, whose possible results move in a large range. Because the higher the standard deviation of an investment is, the more largely is the probability (with same expectancy value) that the obtained result precipitates also more badly or a higher loss can develop.

"Do not trust on all your goods only one ship" said already Erasmus. In the Middle Ages closed several buyers in the trading vessel travel together at economic successes of that do not succeed for an individual commercial expedition to make dependent and also insurances are based on the same principle of the spreading of ristk. Because an insurance functions only, if the resulting risks not completely dependently from each other are.

The "naive diversification" already above addressed follows the law of the large number. Briefly said means this, that an investor its capital divides evenly and invested into different-arranged investments at the same time. This unmethodical, even dispersion of the capital lowers the risk of the portfolio after the number of investments. With 2 investments its risk amounts to only 70 %, with four 50 % and with 16 investments only about 25 % of the risk of an individual investment. Thus however not only mathematically but also actually functioned it presupposes, that the risks are from each other absolutely independent. With the investment of funds one finds however no strict validity for this and therefore is not the naive diversification not the suitable way.

The purposeful diversification permits however a real minimizing the risk. The entire risk can be almost eliminated by purposeful choice of the correct mixing proportion already two of risky investments. The key lies in the fact, that the yields must run as perfectly as possible moving in opposite directions. The specialist speaks of the „correlation“ (= statistic measure for the dependence of two investments). The extent of this dependence is measured with that so-called coefficients of correlation. This can take values between -1 and 1. -1 means, that the two investments are perfectly moving in opposite directions, 1 against it perfectly positive dependence means .
Markowitz pointed out that the correlation between two investments can be determined by purposeful diversification. The lower the correlation between the individual investments, the more risks can be eliminated by the portfolio management.

How can we use this knowledge now? The world-wide, in addition, the European stock markets offer a multiplicity of investments, which run for itself regarded moving in opposite directions. The economic development of Europe is rather to foresee as the world-wide development to define the correlation of individual values so rather. Which however is not called, that non-European rating should not be considered. Certain diversifications are attainable only by the world-wide markets.

Naturally also the correlation between the different investment classes belongs to the diversification.

Result: Diversification, thus the dispersion of the capital on various investments leads lastingly to the lowering of the risk of the portfolio. Moving in opposite directions the individual fitting ever among themselves are, the more risks can by the purposeful composition of the portfolio be minimized. Purposeful diversification between different investment markets, values and investment classes offers a high potential for risk lowering and gaining of high, comparatively stable yields.