Diversification

Balancing Risk and Return for a Smarter Investment Strategy

Most large institutional investors place the principle of diversification at the core of portfolio construction. It’s natural to want to maximize return while reducing risk. This is the difference between wise investment and speculation. As mentioned in the first course of the academy, in finance there‘s a relationship between risk and expected return. A higher level of risk tends to equate to a greater return. However, diversification can tip the scales to a degree, possibly offsetting the higher risk taken in pursuit of higher returns.

Key Points to Understand:

Here are the key takeaways from this page to help you better understand the importance and practical application of diversification in investment strategy:

Understand how diversification reduces risk by spreading investments across non-correlated assets.
Explore diversification across countries, sectors, industries, securities, issuers, and time.
Learn how to balance equities, bonds, and alternative assets in a portfolio.
Recognize emotional biases in investing and how strategies like Dollar Cost Averaging (DCA) help maintain discipline.
Discover how multi-asset ETFs assist in building diversified portfolios tailored to risk preferences.

Why Diversify?

In the world of investing, diversification is a cornerstone principle that helps investors balance risk and return. The key advantage lies in combining non-correlated assets—assets whose performance is not tied to the same market factors. By doing so, investors can build portfolios that are less volatile, as the fluctuations of one asset are unlikely to mirror those of another. Over time, this reduces overall risk, providing a more stable and resilient investment portfolio that’s abler to weather market uncertainties. By spreading investments across different assets, sectors, and geographies, you can mitigate the impact of poor performance from any single investment. This strategy is widely adopted by large institutional investors and can be just as effective for individual investors.

In this section we will deal with different types of diversification:

Diversification across countries

Diversification across sectors and industries

Diversification at the security Level

Diversification at issuer level

Diversification across time

Diversification Helps Address The Psychology of Investing

Investors are naturally emotional, which may make their decisions less rational. Recognizing and managing this is crucial for long-term investment success. One common issue is the tendency to react impulsively to market fluctuations, which can result in buying high and selling low—a value-destroying approach. Thanks to diversification, those fluctuations can be less usual, or at least have a less impactful effect on the investment.

The graph below illustrates the emotional rollercoaster many investors experience. It typically shows how market highs and lows can provoke intense feelings of euphoria and despair, respectively. This graph usually maps the investor sentiment cycle, highlighting phases such as optimism, excitement, and, eventually, panic or despair.

Managing Emotions for Long-Term Success

Source: VanEck.

The key takeaway from such a graph is the importance of maintaining a disciplined investment strategy. Emotional responses to market movements often lead to poor decisions. For instance, the euphoria during market highs might encourage over-investment in risky assets, while the despair during lows might prompt premature selling at a loss.

To counteract these emotional responses, implementing a DCA strategy is highly effective. This involves investing a fixed amount of money at regular intervals, regardless of market conditions. This approach helps smooth out the effects of market volatility and reduces the impact of market timing errors. By sticking to a consistent investment plan and avoiding reactionary decisions, investors can mitigate the psychological impact of market fluctuations and focus on long-term goals.

The Mechanics of Diversification

A diversified portfolio seeks to include assets that do not move perfectly in tandem.

Diversification aims to minimize risk by spreading investments across various assets. The key principle behind diversification is to avoid putting too much capital into a single asset or asset class, which can reduce the impact of a single investment’s poor performance on the overall portfolio. A diversified portfolio seeks to include assets that do not move perfectly in tandem. This means that when one security falls in price, other assets in the portfolio might not, or could even perform well, thereby mitigating overall risk.

A common measure used to assess the degree of correlation between two assets is the correlation coefficient. This metric ranges from -1 to 1 as follows:

Positive Correlation
No Correlation
Negative Correlation

1 indicates perfect positive correlation, meaning the two assets move in the same direction in perfect synchronization.

0 signifies no correlation, where the assets move independently of each other.

-1 reflects perfect negative correlation, meaning the two assets move in opposite directions.

For example, stocks from related companies, such as two firms within the same industry, typically have a correlation coefficient close to 1. This is because their performance is often influenced by similar factors, such as industry trends or specific economic trends. On the other hand, stocks and bonds usually have a correlation closer to 0 or even negative. Stocks and bonds often respond differently to economic events: while stocks may decline during a market downturn, bonds (especially government bonds) might offer stability or even appreciate in value.

Correlation Matrix

	ITX SM	AIR FP	ESPO LN	DAX	SX5E	MXWO	UKX	USGB360D	USGG10YR	GDBR10	GBTPGR10	GUKG10
Inditex	1.00
Airbus	0.55	1.00
VanEck Video Gaming & eSports UCITS ETF	0.42	0.37	1.00
DAX Index	0.71	0.71	0.62	1.00
EURO STOXX 50 Index	0.73	0.72	0.64	0.98	1.00
MSCI World Index	0.48	0.52	0.58	0.71	0.72	1.00
FTSE 100 Index	0.66	0.69	0.56	0.87	0.88	0.71	1.00
US Treasury Bill 1 Year	0.00	-0.02	0.02	-0.01	-0.02	-0.03	-0.04	1.00
US Government Bond 10 Years	0.12	0.13	0.05	0.17	0.18	0.31	0.22	0.03	1.00
German Gov. Bond 10 Years	0.12	0.11	0.02	0.13	0.14	0.08	0.15	0.01	0.57	1.00
Italian Gov. Bond 10 Years	-0.09	-0.18	-0.19	-0.22	-0.22	-0.27	-0.20	0.04	0.16	0.47	1.00
UK Gov. Bond 10 Years	0.14	0.14	0.05	0.14	0.15	0.15	0.18	-0.01	0.58	0.66	0.26	1.00

Source: Morningstar, Asset correlations for time period 11/25/2020 - 11/20/2024. (based on daily returns)

Levels of Diversification

When investing, diversification can be put in practice on four different levels:

Diversification Across Countries
Diversification Across Sectors and Industries
Diversification at the Security and Issuer Levels

Investing across different countries can help to protect your portfolio from risks associated with any single nation. Geopolitical risks are increasingly relevant, and over concentration in a few countries can expose your portfolio. International diversification takes the spreading of risk one step further by not only focusing on assets with different performance characteristics but also incorporating assets from multiple countries. This international approach broadens the variety of potential responses to market shifts, as assets from different regions are influenced by unique economic conditions, regulatory environments, and currency fluctuations. This creates additional layers of diversification, reducing the overall risk by not concentrating investments solely in one market.

In order to minimize the risks arising from single countries, it is common practice to diversify your portfolio across many. Nowadays, geopolitical risks are increasing and need to be properly managed. Moreover, over the last years certain countries have assumed a large weight in the main stock indices, which might potentially lead to portfolios becoming excessively concentrated. Most notably, there is little comment about the risk of the US accounting for more than 70% of the MSCI World Index, the best known global equity index.

The pie chart below highlights the weight of different countries in the MSCI World Index, showing US dominance and the importance of geographical diversification.

Country Weights MSCI World Index

Source: MSCI, Data of October 2024.

The global economy is composed of various sectors, each with its own characteristics and responses to economic cycles. By diversifying across sectors and industries, investors can build a more resilient portfolio that can weather different economic conditions.

A common system for classifying sectors is the Global Industry Classification Standard (GICS). Sectors behave differently from one another in a variety of ways. Some are cyclical - growing at times of expansion and shrinking during contractions - while others are not. Some are more sensitive to interest rate variations while others are not. Logically, a good mix of them sectors prove beneficial. Going beyond sectors, it could be useful to differentiate further between industries and sub-industries, although we suggest keeping things simple.

GICS Sector & Industry Level Diversification

Source: MSCI.

Diversification means spreading your investments to reduce risk. At the security level, this means owning a mix of different types of investments—such as stocks, bonds, and Exchange-Traded Funds (ETFs). Each type of security behaves differently in various market conditions. By combining them, you lower the chance that a drop in one will hurt your entire portfolio. For example, when stocks go down, bonds might hold their value or even go up, helping to balance things out.

At the issuer level, diversification means not putting too much money into any single company. Instead of investing heavily in one business, you spread your investments across many companies, even within the same industry. This way, if one company performs poorly, it won't have a big impact on your overall returns.

Since it's hard to predict which investments will do best, diversification helps reduce big losses and creates a more stable investing experience over time.

Practical Diversification Strategies

To diversify is to invest in a spread of financial instruments with different characteristics that are expected to behave differently under varying market conditions. This approach is designed to reduce the overall risk of a portfolio by ensuring that not all assets will respond similarly to economic downturns or booms.

By holding assets with different performance patterns, investors aim to mitigate losses in one area with gains in another, making it possible to maintain a more consistent and balanced portfolio performance over time. Diversification requires both a scientific approach and an artistic touch. While some institutional investors rely on complex models and extensive research, individual investors can apply simple, pragmatic rules to achieve effective diversification.

Art or Science?

The answer is both. Some institutional investors employ dozens of highly educated (and well paid) experts in order to assess the optimal portfolio mix. You might want to be more pragmatic and apply the following rules of thumb:

Compose the core of your portfolio from equities and bonds.

These are the two largest asset classes and can be the building blocks of your allocation. A common portfolio theory advocates for a 60/40 split, namely to invest 60% in equities and 40% in bonds. Historically, they have tended to move in a relatively uncorrelated fashion, which enhances diversification.

Complement this with other asset classes, such as real estate and commodities. (e.g., gold)

These are the so-called alternative asset classes which can complement a well-diversified portfolio and improve its risk-adjusted characteristics. Especially lately, many experts are advocating to integrate these “alts” in a portfolio, as the new macroeconomic and geopolitical scenario calls for a different allocation.

Your equity portfolio should consist of a good amount of different stocks, ideally from different sectors and geographies.

As previously discussed, effective diversification spans multiple levels, each crucial for constructing a resilient investment portfolio. To facilitate this, we offer three multi-asset ETFs that are designed to achieve diversification across asset classes, countries, sectors, and issuers. Here’s a summary of each:

Multi-Asset ETFs for Easy Diversification

VanEck Multi-Asset Conservative Allocation ETF

VanEck Multi-Asset Balanced Allocation ETF

VanEck Multi-Asset Growth Allocation ETF

Diversification Across Time

Market fluctuations are inevitable, but by investing regularly you can smooth out the ups and downs. Dollar cost averaging allows you to build wealth over time without trying to time the market, which is often a losing game.

Lump Sum vs Dollar Cost Averaging

To say that markets fluctuate would seem an understatement at times. Unfortunately, it’s a natural trait of human behavior to buy when markets are high and sell when they’re low. The best way to avoid this is to adopt diversification by investing over time — learning the discipline of investing regularly without judging markets. For instance, if you invest regularly, like clockwork every month, you might well buy when the markets are high, but you also will buy when they're low. At times of expansion, your amount invested will buy fewer shares, while the contrary is true when the market declines. Over time, this strategy could lower the average price you pay per share. This concept is known as dollar cost averaging (DCA), and it is the foundation of a long-term approach to the stock market. Timing the market is, in fact, extremely difficult, even for the most experienced investors, due to the sheer amount of variables at play.

The following two tables show the difference between an investor who buys every month in a disciplined way, not paying attention to the noise, and another one who tries to time the market.

How dollar cost averaging works

Timing	Amount	Share Price	Share Purchased
Month 1	$1000	$5	200
Month 2	$1000	$5	200
Month 3	$1000	$2	500
Month 4	$1000	$4	250
Month 5	$1000	$5	200
	Total Invested:	Average cost/share:	Total shares purchased:
	$5000	$3.70	1350

Source: VanEck.

Timing	Amount	Share Price	Share Purchased
Month 1	$5000	$5	1000
Month 2	$0	$5	0
Month 3	$0	$2	0
Month 4	$0	$4	0
Month 5	$0	$5	0
	Total Invested:	Average cost/share:	Total shares purchased:
	$5000	$5	1000

Source: VanEck.

By investing the same amount each month, regardless of market conditions, the investor in this example paid an average price of $3.70 per share and accumulated 1,350 shares. In contrast, someone trying to time the market may end up with fewer shares, especially if they miss lower entry points due to uncertainty or hesitation. However, it is important to mention that DCA does not guarantee a profit or protect against loss in declining markets. If prices continue to fall over an extended period, investors may still face losses. Additionally, in a steadily rising market, a lump sum investment made early on may outperform DCA.

Key takeaway: DCA helps reduce the emotional impact of market volatility and encourages consistency. While it can result in purchasing more shares at lower prices, it is not a one-size-fits-all strategy and has its limitations.

Investing Money

Diversification

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