Passive investing part 2: diversification

In this second post of my series of articles focused on passive investing for Europe based investors, I would like to explain why passive investing makes sense as a strategy for an individual investor not only from costs perspective but also from returns perspective. In particular I will write about the impact of diversification.

Diversification

The theory says that there are two risks associated with investing in equities – the market risk and the idiosyncratic risk of the particular company. For example, if you chose to invest your portfolio in 5 stocks with equal amounts invested in each and one of them got into sudden unexpected problems (e.g. German company Bayer), this would disproportionately harm your returns. However, if you invest in a well diversified portfolio, in theory all the individual risks cancel out (negative surprises offset the positive ones) and you end up receiving the “market” return.

Therefore, passive investments in ETFs that offer a wide portfolio of stocks at low fees can be an easy way to harvest the benefits of diversification without much effort.

Of course, in practice diversification is not so simple to do – portfolio can be diversified across countries, sectors or other metrics. Since many ETFs tend to weight their investments based on market capitalization of the companies held, you might often be surprised to find out how much overlap there is between ETFs with seemingly very different aims. I will come back to this topic of how ETF names can be misleading your diversification efforts a bit later. However, general rule is the more mainstream ETF you choose, the more likely you’re going to be just fine.

If you have any questions or feedback, please leave a comment below.

Published by everydayinvesting

Amsterdam based. There will definitely be a bias towards topics relevant to my work. I'm interested in investing, markets, economics, politics, history but also machine learning, statistics and how (whether) all these can be combined. I have questions and let me know if you have answers! Always happy to discuss any of the below and more. - can machine learning be applied to investing? - what's the future of active investment management? - what's the future of passive investment management? - where's the best trade now?

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