Diversification

In simple terms

"Don't put all your eggs in one basket" is the idea behind diversification: spreading money across different investments so that a problem with one does not ruin the whole.

It works, but only against some kinds of risk, and only when the investments really are different.

Two kinds of risk

• Company-specific risk (also called unsystematic risk): events that hit one company, such as a fraud, a failed product, a lost customer or a factory fire.
• Market risk (also called systematic risk): events that hit almost all shares at once, such as a recession, a financial crisis or a sharp rise in interest rates.

Diversification reduces the first. It cannot remove the second.

How spreading money helps

As more independent holdings are added, the effect of any one becomes smaller. Studies of share portfolios have generally found that most of the reduction in company-specific risk comes from the first few dozen holdings, after which extra holdings add little.

Correlation decides how much it helps

Diversification works because different holdings do not all fall at the same time. Correlation measures how much they move together, from +1 (perfectly together) to −1 (perfectly opposite), as the correlation lesson explains.

Most shares have positive correlations with each other, because market risk affects them all, so diversifying among shares alone cannot remove market risk. Diversifying across asset classes, such as shares and fixed income, can reduce it further, as the asset allocation lesson explains.

False diversification

A portfolio can hold many names and still be concentrated:

• Same sector: ten banks, ten IT companies or ten metal producers share the same risks.
• Same group: several companies controlled by one business group can be hit by the same governance or debt problem.
• Same theme: many shares that all depend on low interest rates, a commodity price or one export market.
• Overlapping funds: several mutual funds that hold mostly the same large companies.

Check what drives each holding, not just how many there are.

Diversification in a crisis

In severe market falls, correlations between shares tend to rise: almost everything falls together. Diversification among shares then helps less, just when it is most wanted. This is another reason it cannot replace keeping enough money in safer assets for near-term needs.

Over-diversification

Beyond a point, adding holdings brings costs:

• Each new holding adds very little extra protection.
• The portfolio becomes hard to monitor, and its results start to look like an index, but with higher costs and more effort.
• Good ideas get diluted into tiny positions.

For many investors, a low-cost index fund gives broad diversification more simply than a long list of individual shares, as the index funds lesson explains.

Why it matters

Diversification is the most reliable way to stop a single bad event from causing a permanent loss. Understanding its limits, that it cannot remove market risk, that it depends on correlation, and that many names can still hide concentration, prevents false confidence.

Limitations

Correlations change over time and rise in crises. Diversification reduces the damage from individual failures but also caps the gain from any single great investment. It does not protect against paying too much for everything, or against the market as a whole falling.

Common mistakes

• Counting names instead of risks.
• Owning many shares in one sector or group.
• Holding several funds that own the same shares.
• Expecting diversification to prevent losses in a market crash.

Try it yourself

1. List the holdings in a portfolio you know, real or imagined.
2. Group them by sector, business group and the main factor that drives them.
3. Note the largest share of the portfolio exposed to any single sector, group or factor.
4. Decide whether the portfolio is as diversified as its number of holdings suggests.