Diversification explained – How to minimize risk and maximize returns in investing

Especially in times of global crises and significant fluctuations in stock prices, forecasts, and economic indicators, uncertainty about investments increases. And rightfully so. So, how should you decide which path to take to protect or grow your wealth? A smart strategy is diversification.

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What does diversification mean?

Diversification in investing means spreading risk by making investments in different financial products. A diversified portfolio is created through the combination of various types of assets.

What does optimal diversification look like?

A perfectly diversified portfolio that prepares a professional or private investor for every possible market scenario does not exist. However, distributing assets across different investment classes and applying appropriate risk weighting can significantly improve portfolio stability.

With a specially designed all-weather investment strategy, it is even possible to achieve returns similar to pure stock investments while taking on only one-third of the risk associated with them.

Simply put: Returns and security go hand in hand

Put simply, maximizing returns while ensuring high security in an investment is usually not possible. In other words, those seeking maximum security in their investments should not chase the highest returns but rather be satisfied with lower yet more realistic figures for value development.

Saving and security in investments

Many potential investors never take the step into investing because they want to avoid any risk when managing their savings. As a result, their money often remains in a savings account or is parked in a fixed-term deposit or a flexible daily savings account.

In reality, no one has to completely avoid these forms of investment. On the contrary, experienced financial advisors even recommend keeping at least two to three months’ worth of salary in flexible checking or savings accounts. This ensures there is always enough liquidity available for unexpected expenses, such as car repairs or replacing a broken washing machine. Investments should primarily involve capital that can be set aside or specifically saved for retirement.

How can investors diversify their assets?

First, investors should have a clear understanding of their goals and investment horizon. When it comes to risk diversification, it does not matter whether 100 euros are saved each month over several years or a one-time inheritance of 250,000 euros is invested. In both cases, a well-balanced investment structure should be maintained. A variety of asset classes are available for this purpose:

Bank deposits, savings accounts, fixed-term deposits, daily savings accounts
Stocks
Investment funds, equity funds, bond funds, mixed funds, ETFs (index funds)
Bonds, pension securities, fixed-income securities
Commodities, precious metals, gold
Real estate, real estate funds, REITs
Private equity, tangible assets
Crowdfinancing (investments in private loans, corporate loans, real estate)
Cryptocurrencies

The 3-step rule of thumb for diversification

Secure and relatively liquid deposits form the foundation of wealth (savings accounts, fixed-term deposits, daily savings accounts).
For medium- to long-term wealth building, capital- and income-generating investments are added (fixed-income securities, investment funds, ETFs, real estate funds, dividend stocks).
High-yield and opportunity-rich investments are included to achieve a higher overall return (stocks, commodities, private equity, crowdinvesting, cryptocurrencies).

In all investment forms, assets should be selected strategically from different regions (Europe, USA, emerging markets) and industries (industry, services, technology, real estate).

Avoiding concentration risk in diversification

Concentration risk arises when investment capital is allocated to only one or a few investments. Many people who prefer safe investment options tend to put their money into real estate, also known as “concrete gold.” The housing market has been turbulent in recent years, with rising interest rates and economic fluctuations further emphasizing the importance of diversification.

Owning a home for personal use was traditionally seen as a way to eliminate rent expenses, but changing market conditions mean this is no longer always the case.

However, problems can arise when real estate is purchased solely for rental purposes. Many investors underestimate the effort required for property management, the risk of rental vacancies, and the costs of renovations and maintenance. A better approach is to invest in real estate funds or stocks of real estate companies, as these investments allow investors to exit the market more easily.

“Diversification is protection against ignorance. It makes little sense for those who know what they are doing.” (Warren Buffett)

Other scenarios for concentration risk can arise from investing solely in the stocks of one company, government bonds from a single country, or turning to gold as an overreaction to an economic downturn. For example, shareholders of major energy providers faced difficulties due to the energy transition, while investors holding Volkswagen securities were affected by the emissions scandal. However, this does not mean that owning shares in the automotive industry is inherently bad. Simply spreading investments across multiple car manufacturers would have provided significant diversification.

The same applies to government bonds. Those who buy only highly secure German federal bonds face virtually no risk of default but also earn no interest. Purchasing bonds from emerging markets or stocks from companies based in these regions offers the potential for higher returns but also comes with greater volatility. This is why diversification within a portfolio is always essential.

The guiding principle for investors should be: prioritize bonds from stable countries that at least preserve wealth, while selectively incorporating high-yield bonds from emerging markets to take advantage of return peaks.

Examples of diversification in a portfolio

There are numerous examples of well-balanced portfolios. These can serve as guidelines for private investors but should always be tailored to individual needs, goals, and life circumstances.

For instance, investors who are close to retirement should invest less in stocks or long-term tangible assets. Instead, their wealth should already be shifted toward safer asset classes such as fixed-income securities, savings accounts, or real estate.

Investors who want to build wealth and are willing to take on controlled risks.
Investors who primarily seek inflation protection and aim to preserve the value of their assets.

A common recommendation for portfolio diversification is to allocate each asset category in equal parts. This results in a wealth structure composed of 25% stocks, 25% bonds, 25% cash, and 25% gold. Precious metals primarily serve as a safeguard, acting as the “last resort” in case all markets crash and cash holdings lose value due to inflation.

How to stay organized while diversifying

As a complement to an investment portfolio, real estate, commodities, or crowdfinancing investments can be included. Younger investors, in particular, may benefit from a higher proportion of stocks and a lower allocation to precious metals as a safeguard (5-10%).

It is also advisable to combine investments with government or employer-sponsored funding programs, such as occupational retirement plans, which have received mixed reviews. The financial benefits, such as direct subsidies or tax advantages, should not be overlooked. A personally owned property also serves as a secure asset but is not typically considered an investment in a diversified portfolio.

To keep track of different investments and assets, it is essential to consolidate them into an organized overview.

Why diversifying risk in investments makes sense

A well-diversified portfolio reduces overall investment risk. This means that the average risk of the entire portfolio is lower than the average risk of the highest-yielding asset classes. At the same time, a diversified portfolio offers higher overall returns compared to safer investments like bank deposits or fixed-income securities.

At Invesdor, investors can efficiently diversify their portfolios through three investment types, each catering to different investment strategies. To learn more about these options, check out our guide: What’s the difference between debt, equity, and convertible bonds?

Additionally, you can explore our open funding rounds for high-yield investment opportunities.

Keep in mind that even if you feel well-informed, you may not be aware of every detail regarding an investment opportunity. Or, as a famous star investor once put it: