Written by Julia Khandoshko, CEO at the European broker Mind Money
The saying “do not put all your eggs in one basket” exactly captures the essence of investment diversification, a strategy designed to spread risk across different assets. Today, many stress the necessity of diversification due to current market conditions. However, it is important to question how well traditional notions of diversification align with these new circumstances.
For example, the gap in returns between the S&P 500 and its equal-weighted counterpart is currently at its widest in 15 years, underscoring the need to diversify beyond AI heavyweights like Nvidia. This raises the question: is diversification becoming a more complex instrument? And if yes, how to diversify competently?
Classic diversification strategies are losing their relevance
The classical theory of portfolio management is based on two key coefficients: alpha and beta. Beta reflects how much the stock fluctuates with the index, while alpha shows how much the stock moves independently of the index. A generally accepted investment approach is that the task of the manager or investor is to overtake the index. To do this, on the one hand, it is necessary not to buy similar assets and on the other hand, not to completely avoid including them, so as not to simply get a duplicate index.
However, the problem is that the world has changed significantly since the 60s when this concept was formed. Previously, diversification was understood as the presence of large-cap stocks and commodities in a portfolio, for example, Coca-Cola shares and gold. But today the Coca-Cola stock and gold are more interconnected than 60 years ago. Trying to find real diversification has become one of the main tasks. Previously, market-neutral strategies and portfolio management theory worked effectively, but now they are losing relevance. The world has become more globalized, and diversification today is not just a combination of gold, stocks and bonds.
Diversification becomes more complex along with the world does
Today, diversification entails two main approaches. The first is the use of active strategies that can ensure independence from global economic and political changes. The matter is that when investors buy bonds, S&P or other shares, they buy assets closely linked to geopolitical risks. By including the arbitrage strategies that do not depend on the decisions of the US Federal Reserve System, active management excludes geopolitics from investments. This is an approach that is not suitable for every retail investor and might be a tool for professional brokers and asset managers. Nevertheless, it is a solid option to create a sustainable and independent investment portfolio.
Besides active strategies, there is a second diversification method, and it is investing in emerging markets (EM). They have become a way to diversify as real business is presented in India, China, Brazil or other countries. Unlike investments related to geopolitics, investing in real businesses in developing countries allows you to make a bet on real economic growth. For example, by buying pharmaceutical companies in India, you gain access to a market of one and a half billion people, and not just betting on the future of the Fed.
Successful diversification is to know exactly to what your assets are linked to
In conclusion, the traditional approach to diversification must be adjusted to the realities of a globalized market. The rules of the game have changed, and investors can no longer rely solely on traditional portfolio management theories. Instead, diversification today requires active strategies and emphasising concepts that go beyond geopolitical dependencies such as infusing funds to a real economy sector.
Furthermore, modern diversification calls for sophisticated active management techniques, including arbitrage strategies that mitigate reliance on macroeconomic policies like those of the US Federal Reserve. Ultimately, no matter which strategy to diversify was chosen, when buying assets, an investor must clearly understand what exactly he is acquiring and how much this investment is related either to geopolitical factors or real business. Thus, the key to successful diversification lies in answering one question to yourself: do I buy a real asset or just the future decision of regulators?
