Diversification
What is Diversification?
Diversification is spreading investments across different assets to reduce risk without necessarily lowering expected return.
Because asset prices don't all move together, holding a variety of investments cushions losses when any one performs poorly. It reduces unsystematic (asset-specific) risk but cannot eliminate market-wide risk.
Diversification: a worked example
Priya has $10,000 and two candidate stocks: an umbrella maker and a sunscreen maker. A rainy summer sends umbrellas up 30% and sunscreen down 20%; a sunny summer flips them. All $10,000 in umbrellas is worth either $13,000 or $8,000, a $5,000 swing on a coin flip, with an average of $10,500. Split $5,000 into each instead: rainy gives $5,000 × 1.30 + $5,000 × 0.80 = $6,500 + $4,000 = $10,500, and sunny gives the same $10,500. The average is unchanged, but the range collapses from $5,000 to zero. The risk that vanished was the weather, which pushes the two holdings in opposite directions.
The mistake students make with diversification
Counting holdings is not the same as diversifying. Twenty stocks that rise and fall together, say twenty firms in one industry, behave almost like one big position; what does the work is low correlation between what you own, not the number of tickers. The opposite error is expecting diversification to protect you in a broad downturn. Spreading money removes asset-specific risk, so one firm's bad quarter barely dents you, but when the whole market falls, every holding falls with it.
Diversification questions
Does diversification lower your returns?
Diversification does not lower expected return, because a portfolio's expected return is simply the weighted average of what its pieces are expected to earn. Hold two assets each expected to return 8% and the mix is still expected to return 8%; only the spread of possible outcomes narrows. What diversification does give up is the extreme upside of having bet everything on the one asset that happened to win.
What risk can diversification not eliminate?
Diversification cannot eliminate systematic risk, the market-wide risk that moves nearly every asset at once: interest rate shifts, recessions, broad panics. Spreading money across a hundred firms removes the danger that any one of them mismanages itself, which is unsystematic risk, but it leaves you fully exposed to whatever moves the whole market. Cutting systematic risk means holding less of the market, not more names within it.
How does correlation affect diversification?
Correlation decides how much diversification buys you. Two assets that move in perfect lockstep, a correlation of +1, give no risk reduction at all when combined. Assets that move independently, a correlation near zero, cut the swings noticeably. Assets that move in opposite directions, a correlation near -1, can cancel each other's swings almost entirely, which is what pairing an umbrella maker with a sunscreen maker does. Lower correlation, more benefit, at the same expected return.
Related terms
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