What is diversification and why is it smart?

4 Jul 2024

5 min

When you start investing, you will often hear from others that you should diversify. What does this actually mean, and why should you do it? We will explain it to you in this blog!

Diversification

Diversification means that you spread your investments so that your return is not dependent on a single investment. This is often summarized as "not putting all your eggs in one basket".

A key concept here is "correlation". Two investments are correlated if their returns move together. For example, if the stock of company A falls, the stock of company B remains stable or even rises. To reduce risk, you should invest in assets that do not all move in the same direction. This can be done by investing in different asset classes (such as stocks, bonds, real estate, etc.), sectors and geographic regions.

Different ways to diversify

Different asset classes
One way to diversify is to invest in different categories, called ‘asset classes’. The best known are stocks, bonds, real estate and commodities. Each asset class is influenced by different factors. For example, the return on bonds depends mainly on interest rates, while stock returns are more related to economic growth.

Different companies and sectors
Diversification can also be achieved by investing in different companies and sectors. By spreading across sectors, you are less dependent on specific trends within a sector. For example, negative developments in healthcare can be offset by positive developments in the technology sector.

Research suggests that a portfolio of 25–30 different stocks, spread across different sectors, provides sufficient diversification. Adding more than 30 stocks generally does not yield significant additional benefits.

Different countries
You can also diversify by investing in different countries or regions. This protects you from local economic problems. For example, a recession in the Netherlands does not necessarily mean that Japan will experience the same. Although the global economy is becoming increasingly integrated, geographical diversification remains a valuable diversification strategy.

How can you diversify your investments?

There are three options for diversified investing: (1) buy an ETF, (2) have your money invested by an asset manager, and (3) build a diversified portfolio yourself.

Option 1: Buy an ETF
An ETF (Exchange Traded Fund) is an investment fund that is traded on the stock exchange, similar to a stock. An ETF tracks the performance of a specific market index, such as the S&P 500. By buying an ETF, you indirectly invest in all the companies in that index.

Advantages:

  • Quick and easy diversified investing.

  • Generally low costs, sometimes without transaction costs.

  • Suitable for small amounts.

Disadvantages:

  • Most ETFs are entirely stocks or bonds, although there are some multi-asset ETFs. However, these can be a lot more expensive.

Option 2: Investing through an asset manager
A wealth manager manages your investments and provides a mix of shares, bonds and other asset classes. They continuously monitor your investments and make adjustments when necessary.

Advantages:

  • Managed by experts, you don't have to delve into them yourself.

  • Good diversification across different asset classes and regions.

Disadvantages:

  • More expensive, with annual costs between 0.5–1.5%.

  • Often a minimum deposit required.

Option 3: Create a diversified portfolio yourself
You can also build a diversified portfolio yourself by making separate investments. However, this does require knowledge and research.

Advantages:

  • Full control over your investments.

Disadvantages:

  • Can be expensive due to transaction costs.

  • Requires a lot of time and research to be well diversified.

Conclusion

Diversification is a crucial strategy to reduce the risk of your investments. This can be achieved by investing in different asset classes, sectors and geographic regions. Whether you choose an ETF, an asset manager or build a portfolio yourself, make sure you always aim for good diversification to protect your investments.

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