Finance
Diversification
Spreading money across different investments so that no single one's bad outcome can sink the whole portfolio — reducing risk without necessarily giving up expected return.
Definition
Diversificationis spreading investments across multiple different assets, rather than concentrating money in just one or a few, so that a bad outcome in any single investment doesn't disproportionately damage the whole portfolio.
Why this exists
Per Risk & Return, every individual investment carries some uncertainty about its outcome. But not all of that uncertainty comes from the same source: some of it is specific to that one investment alone — a single company's product fails, its factory has a bad year, its leadership makes a poor decision — while some of it is shared across nearly everything at once, like a broad economic downturn that drags most investments down together.
The risk that's specific to one investment can be reduced by simply not putting all your money into that one thing. Hold twenty different companies instead of one, and a single company having a uniquely bad year barely dents your overall results, because the other nineteen aren't affected by that company's specific problem — some might even be having an especially good year at the same time. Spread across enough different, sufficiently unrelated investments, this company-specific risk mostly cancels out, without you having had to give up any expected return to get that benefit — which is why diversification is sometimes described as one of the only ways to reduce risk without a real cost attached.
The risk shared across everything at once can't be diversified away this way, because by definition it affects all or most of your holdings simultaneously — owning a hundred companies instead of one doesn't protect you if the whole economy slows down and drags nearly every company down with it. Diversification reduces the first kind of risk, not the second.
Worked example
Compare holding all your money in a single small company's stock against spreading it across 20 unrelated companies.
Single company, hit by a product recall: Portfolio impact: roughly a 40% drop (the whole thing was exposed) 20 unrelated companies, one of them hit by the same recall: Portfolio impact: roughly a 2% drop (only ~1/20th of the portfolio was exposed; the other 19 aren't affected by that company's problem)
But if a broad recession hits and most companies decline together, both the single-company holding and the 20-company portfolio would likely fall — diversification doesn't protect against that shared, economy-wide risk.
Try it yourself
If just one holding is hit
-2.00%
portfolio-wide impact
If the shock hits every holding at once (market-wide)
-40.00%
How the math works
This assumes an equal-weighted portfolio of 20 holdings, with the other holdings otherwise flat. If the shock is specific to just one holding, only 5.0% of the portfolio is exposed to it, so the portfolio-wide impact is the shock divided by the number of holdings: -40.0% / 20 = -2.00%.
But if the same shock hits every holding simultaneously — a broad market decline, for instance — every holding drops together, so the portfolio-wide impact is the full -40.00%, no matter how many holdings the portfolio has. Diversification reduces the first kind of risk; it can't touch the second.
Common misconceptions
“Diversification guarantees you won't lose money.”
It reduces exposure to any single investment's specific bad luck, but it can't protect against risk that affects everything at once, like a broad market downturn.
“Diversification always means you make less money than concentrating your money in the single best investment.”
Only in hindsight, if you could have known which single investment would do best. Going in, you can't know that in advance — diversification exists specifically because you can't reliably pick the one winner ahead of time.
“Owning many stocks is automatically diversified.”
If all the stocks are in the same industry or exposed to the same specific risk — twenty different oil companies, for instance — they can still move together and fail to protect you the way diversification across genuinely unrelated investments would.
Also in the Glossary: Diversification