Key takeaways
- Diversification means spreading money across different investments so that a loss in one hurts the whole portfolio less.
- It reduces the risk tied to individual companies or sectors, but not the risk that most markets fall together.
- Asset allocation, the split between stocks, bonds and cash, sets the overall level of risk; diversification spreads risk within and across those categories.
- Over time a portfolio drifts from its intended mix; rebalancing brings it back, usually by trimming what has grown and adding to what has lagged.
- Diversification does not guarantee a profit or protect against loss in a falling market.
Investor.gov sums up diversification with an old saying, "Don't put all your eggs in one basket": spreading money among different investments to reduce risk, in the hope that if one loses money, the others make up for it. The idea is simple; this guide sets out what it can and cannot achieve.
How diversification reduces risk
Any single company can disappoint. Investor.gov notes that a stock's price can be affected by factors inside the company, such as a faulty product, or by events it has no control over, such as political or market events. If all your money is in one stock, one such event can do serious damage. Spread across many companies in different industries, the same event becomes a small part of the whole.
A simple illustration. Compare a portfolio of one stock with one of 20 stocks in equal amounts, and suppose one company collapses by 80%:
| Portfolio | Loss from that one company |
|---|---|
| 1 stock | 80% of the portfolio |
| 20 equal stocks | 80% × 1/20 = 4% of the portfolio |
The other 19 holdings might be up or down, but no single surprise can sink the portfolio. Investor.gov's stocks guide makes the same point: the risks of holding stocks can be offset in part by investing in a number of different stocks, and in other kinds of assets such as bonds.
The risk that spreading cannot remove
Wikipedia's article on diversification puts it in terms of two kinds of risk. Buy every stock in the S&P 500 and you are still exposed to movements in the index itself; that risk exists however many of its stocks you hold, so it is called non-diversifiable, systematic or market risk. Buy a single stock and you also carry the risk of that one company, which can be reduced by holding many stocks: diversifiable, unsystematic or security-specific risk.
So diversification:
- does reduce the chance that one bad outcome ruins the portfolio;
- does not guarantee a profit;
- does not protect against losses when broad markets decline.
Wikipedia notes that the variance-reducing effect is diminished, though not eliminated, when holdings' returns are positively correlated, and Investor.gov suggests spreading investments across industry sectors as well as across companies. Owning 20 technology stocks is more diversified than owning one, but much less than owning 20 stocks across different industries and countries. Volatility explained covers how these movements are measured.
Asset allocation: the bigger decision
Investor.gov treats diversification alongside asset allocation, dividing investments among broad categories such as stocks, bonds and cash. Investor.gov explains that conditions that cause one asset class to perform poorly may improve returns for another. The allocation decision, Investor.gov stresses, is personal and depends on two things:
- Time horizon: how long you plan to invest before you need the money. Investor.gov notes that investors with a longer horizon may feel comfortable taking on riskier or more volatile investments.
- Risk tolerance: your ability and willingness to lose some or all of your original investment in exchange for potentially greater returns.
Risk tolerance and time horizon looks at both questions. Investor.gov also cautions that free online questionnaires may be biased toward products sold by whoever sponsors them.
Diversifying with funds
Investor.gov notes that some investors find it easier to diversify by owning mutual funds or ETFs, which pool money from many investors and make it easy to own a small portion of many investments. It also cautions that a fund will not necessarily provide diversification, especially if it is narrowly focused, such as on one industry sector, and suggests checking the top holdings of the funds you own. A broad index fund seeks to track a whole index; a sector fund focuses on one industry.
Rebalancing
Over time, the parts of a portfolio grow at different rates, and the mix drifts. Investor.gov's example: a portfolio set at 60% stocks that rises to 80% stocks after strong gains is now riskier than intended. Rebalancing restores the original mix, by selling some of what has grown or adding money to what has lagged. Investor.gov notes that some financial experts advise rebalancing on a schedule, such as every six or twelve months, and others when a category drifts past a set percentage, and that rebalancing tends to work best when done relatively infrequently. In a taxable account, selling to rebalance can create a tax bill, a consideration covered in capital gains on stocks.
Seeing concentration in practice
Concentration is easier to grasp when you watch one position dominate a portfolio's swings. Learn to Trade Stocks Beginner lets you build a practice portfolio with a virtual balance and track each position's profit and loss, so you can see how a large holding moves the whole. It sits with our education apps; the investing basics hub has the related guides.
Good to know
Frequently asked questions
What is diversification?
Does diversification prevent losses?
What is the difference between diversification and asset allocation?
What does rebalancing mean?
Sources
- Asset Allocation and Diversification (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Diversification (glossary) (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Stocks – FAQs (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Diversification (finance) (opens in a new tab)Wikipedia — accessed
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