Investing Basics · definition
Diversification
Diversification is the practice of spreading investments across different assets, sectors or regions so that no single holding can dominate the outcome of a portfolio.
Diversification means not putting all your eggs in one basket. In investing, it is the practice of spreading money across different assets, for example many stocks instead of one, or a mix of stocks and bonds, so that the poor performance of any single holding has a limited effect on the whole portfolio.
Key takeaways
- Diversification reduces the impact of any single investment's failure on a portfolio.
- It works because different assets often do not move in the same direction at the same time.
- It reduces unsystematic risk (company-specific risk) but not systematic risk (market-wide risk).
- Pooled products such as ETFs and index funds are common ways portfolios hold many assets at once.
Why diversification works
The logic rests on correlation: the degree to which assets move together. If two holdings respond differently to the same event, say, an oil producer and an airline when oil prices change, losses in one can be offset, partly or fully, by the other. A portfolio of imperfectly correlated assets therefore tends to swing less violently than its individual components. Harry Markowitz formalised this insight in 1952 in what became modern portfolio theory, work later recognised with the Nobel Memorial Prize in Economic Sciences.
What diversification cannot do
Spreading holdings eliminates much of the risk specific to individual companies, a fraud, a failed product, a bankruptcy. It cannot remove market-wide risk: in a broad crash, most assets fall together as correlations rise. Diversification narrows the range of outcomes; it does not guarantee a profit or prevent loss, a caveat regulators such as the U.S. Securities and Exchange Commission state explicitly.
Dimensions of diversification
Portfolios can be spread along several dimensions at once: across companies, across industries, across countries and currencies, across asset classes (equities, bonds, cash, real assets) and across time. Each dimension addresses a different cluster of risks; which mix is appropriate depends on someone's situation and is a question for personal financial advice, which this encyclopedia does not provide.
Frequently asked questions
How many stocks make a portfolio diversified?
Academic studies have found that much of the company-specific risk in an equal-weighted portfolio diminishes somewhere between 20 and 30 stocks, though the exact number depends on how the stocks are chosen and how correlated they are. Broad index funds hold hundreds or thousands.
Can a portfolio be over-diversified?
The term is sometimes used for portfolios that hold so many overlapping assets that they mirror the market while still paying active-management costs. The marginal risk reduction from each additional holding shrinks as a portfolio grows.
Sources
This entry is for education only. Investing Value describes how financial concepts work; it does not provide investment, tax or legal advice, and nothing here is a recommendation to buy or sell any asset.