Glossary
Diversification
Spreading money across many investments that do not move in lockstep, so no single loss can do too much damage.
Diversification means holding a mix of investments whose fortunes are not tied together, so that a setback in one is cushioned by the others. A single company can go bankrupt; a portfolio of 500 companies across industries is very unlikely to lose them all at once. The goal is not to avoid losses but to avoid the kind of concentrated loss a portfolio cannot recover from.
Why it works
Each stock carries two kinds of risk. Company-specific risk comes from things like a failed product, a fraud or a lost lawsuit. Market risk comes from recessions, interest rates and panics that hit nearly everything. Adding more, and more varied, holdings shrinks the first kind, because unrelated surprises tend to cancel out. It cannot remove the second.
The less the holdings move together, measured by their Correlation, the more risk the mix removes for the same expected return.
Ways to diversify
- Within stocks: across companies, sectors, sizes and countries. A broad Index fund does this in one purchase.
- Across asset classes: stocks, bonds, cash and sometimes real estate or commodities. That is the domain of Asset allocation.
- Across time: investing gradually, for example through Dollar-Cost Averaging.
Limits and misconceptions
Owning many funds is not the same as being diversified if they all hold the same large stocks. Correlations also tend to rise in crises, so diversified portfolios still fall in a broad selloff; in 2022 stocks and bonds dropped together. Over-diversifying into dozens of overlapping funds mostly adds cost and complexity. And diversification guarantees nothing: it lowers the odds of a catastrophic loss, not the possibility of any loss.