The essentials
- Spreading money across many investments reduces the damage any one can do.
- Diversification works best across assets that do not all move together.
- It reduces risk but does not remove the risk of the whole market falling.
Why it works
A single company can fail. A hundred companies rarely all fail at once. By holding many investments, the losses on some are offset by gains or smaller losses on others. This reduces the risk specific to individual companies without necessarily reducing expected returns, which is why it is often described as the closest thing to a free lunch in investing.
Layers of diversification
| Layer | Spread across | Protects against |
|---|---|---|
| Companies | Many shares rather than a few | One company's collapse |
| Sectors | Technology, healthcare, energy, finance and more | Problems in one industry |
| Countries | Several regions | One economy or currency struggling |
| Asset classes | Shares, bonds, cash, possibly property | Stock market falls |
Correlation
Correlation measures how closely two investments move together. Two oil companies are highly correlated; shares and high-quality government bonds have often been less so, though in some periods, such as when inflation rose sharply, both fell together. Diversification helps most when holdings are not closely correlated.
Hidden concentration
- Overlapping funds: three funds with different names may all hold the same large companies.
- Home bias: many investors hold mostly shares from their own country.
- Employer shares: owning a lot of the company you work for ties your income and savings to the same risk.
- Market-cap weighting: in major indices, the largest companies can make up a large share of the total.
Rebalancing
Over time, the investments that rise grow to a larger share of the portfolio. Rebalancing means selling some of those and buying what has lagged, to return to the chosen mix. Some investors do this once a year; others when a holding drifts beyond a set band. Consider costs and taxes when doing so.
What diversification cannot do
It does not prevent losses when the whole market falls, and it means you will always own some things that are doing badly. That is the point: you give up the chance of holding only the best performer in exchange for avoiding holding only the worst.
Reader questions
How many shares do I need to be diversified?
Research suggests company-specific risk falls sharply over the first few dozen holdings, but a broad index fund achieves far wider diversification in one purchase.
Can you be over-diversified?
Holding many overlapping funds adds complexity and cost without much extra benefit. The aim is breadth, not a large number of products.