Diversification

Diversification means spreading money across investments that do not all move in the same way, so that a loss in one is partly offset by others. It is often called the only free lunch in finance, a phrase associated with Harry Markowitz, because it can lower risk without necessarily lowering expected return. The benefit depends entirely on correlations: owning ten stocks that move together is barely diversified, while owning a few assets that behave differently can reduce risk substantially.

The maths of diversification#

For two assets with equal weights and equal volatility, portfolio volatility depends on their correlation.

The lower the correlation, the larger the risk reduction. See Covariance and Correlation.

How many holdings?#

For a portfolio of N equally weighted assets, each with volatility sigma and average pairwise correlation rho:

Portfolio volatility = sigma × Square root of (rho + (1 - rho) / N)

As N grows, portfolio volatility approaches sigma times the square root of rho. That floor is the systematic risk that diversification cannot remove.

Systematic and specific risk#

Markets do not reward specific risk in theory, because it can be diversified away for free. See Alpha and Beta.

Diversification fails when you need it most#

During crises, correlations between risky assets tend to rise as investors sell everything. In 2008 most stock markets, corporate bonds and commodities fell together. In 2022, stocks and bonds both fell sharply as inflation and interest rates surged. Diversification still helps over time, but plan for periods when it weakens. See Correlation Management and Systemic Risk.

Ways to diversify#

Common mistakes#

1. False diversification: many funds that hold the same large stocks.
2. Ignoring correlation: counting positions instead of measuring how they move together.
3. Diworsification: adding poor investments just to spread money around.
4. Home bias: concentrating in one's own country or employer. See Concentration Risk.
5. Assuming stable correlations through crises.

Diversification for traders#

A trader with five open positions in highly correlated cryptocurrencies effectively has one large position. Measuring correlation between open trades and limiting total risk keeps a bad day from becoming a disaster. See Correlation-Adjusted Sizing and Portfolio Heat.

Frequently asked questions#

What is diversification?#

Spreading investments across assets that do not move perfectly together, reducing overall portfolio risk.

How many stocks do I need to be diversified?#

Much of the specific risk is removed with roughly 20 to 30 stocks across sectors, but market risk remains no matter how many you hold.

Does diversification work in a crash?#

It helps less, because correlations between risky assets often rise in crises; holding truly different assets, such as high quality government bonds or cash, helps most.

Next, learn how to manage correlations actively in Correlation Management.