What is Diversification?
Diversification is the principle of spreading your investments across different asset classes, sectors, and geographies to reduce risk. By not putting all your money in one place, you protect your portfolio against losses in any single investment.
Diversification spreads investments across multiple assets to lower overall portfolio risk without reducing expected return. More assets = less volatility; fewer assets = more risk.
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Step-by-step worked examples
You have $10,000. Put $6,000 in stocks (volatility 20%) and $4,000 in bonds (volatility 8%). Stocks and bonds have −0.3 correlation. Find portfolio risk.
Portfolio Risk = √(0.6²×0.2² + 0.4²×0.08² + 2×0.6×0.4×(−0.3)×0.2×0.08) = √(0.0144 + 0.001024 − 0.002304) = √0.01312 = 11.45%
Compare 1 stock (20% risk) vs portfolio of 10 uncorrelated stocks. Roughly how much does risk drop?
1 stock: 20% risk 10 uncorrelated stocks (equal weight 10% each): portfolio risk ≈ 20%/√10 ≈ 6.3% Risk reduced by ~68%
Your portfolio: 50% US stocks, 30% international, 20% bonds. If US market drops 15% but others rise 5%, net portfolio change?
Change = 0.5×(−15%) + 0.3×(+5%) + 0.2×0% = −7.5% + 1.5% = −6% Diversification cushions the blow
Flashcards
Quick quiz
Q1.Diversification reduces which type of risk?
Q2.60% stocks (20% volatility) + 40% bonds (8% volatility), −0.3 correlation. Approximate portfolio risk?
Q3.Two highly correlated investments (ρ=0.95)?
Q4.Why add international stocks to a US portfolio?
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Common mistakes
Diversification guarantees no losses. — Correct: It reduces volatility and unsystematic risk, but market downturns still hurt.
Owning 50 similar stocks is diversified. — Correct: Correlation matters. 50 tech stocks move together. Mix sectors, geographies, and asset types.
Once diversified, never rebalance. — Correct: Rebalance annually to maintain target weights as prices shift.
Bonds always offset stock losses. — Correct: Only if they're negatively correlated — in rare market crises, both can fall.
FAQ
What is the diversification principle?
Spread investments across assets, sectors, and geographies to reduce risk without sacrificing expected return.
How do you measure diversification?
By correlation (−1 to +1) and portfolio risk formula. Lower correlation and more assets = better diversification.
Can you diversify away all risk?
No. Systematic (market) risk remains. Diversification removes unsystematic (company-specific) risk only.
Diversification benefits in a recession?
Yes, if assets have low/negative correlation. Bonds often hold steady when stocks fall.