Diversification

Diversification is spreading money among different investments, across and within asset categories, so that no single holding can cause a major loss.

What it means

The SEC's beginners' guide to asset allocation sums diversification up as "don't put all your eggs in one basket" and describes it as spreading your money among various investments in the hope that if one loses money, the others will more than make up for those losses. The guide states that a diversified portfolio should be diversified at two levels: between asset categories such as stocks, bonds and cash, and within each category, by choosing investments in segments that may perform differently under different conditions. The SEC also cautions that owning four or five individual stocks does not diversify the stock portion of a portfolio; it suggests at least a dozen carefully selected stocks, and notes that a total stock market index fund can own thousands of companies in a single holding.

Hypothetical example: $50,000 in a single stock that falls 40% loses $20,000. Spread across 10 stocks, with one falling 40% and the rest flat, the loss is $2,000, or 4%. See the concentration calculator.

What it cannot do

Diversification reduces company-specific risk, the chance that one firm's failure dominates results, but it does not remove market risk. In a broad bear market, most stocks fall together, and a portfolio of a hundred stocks still declines with the index. FINRA's asset allocation page says diversification reduces the risk of major losses from over-emphasizing a single security or asset class, and the SEC guide notes that the three major asset categories have historically not moved up and down at the same time, so holding stocks, bonds and cash together has reduced portfolio swings. A fund focused on a single industry does not provide instant diversification, and adding holdings adds fees. The benefit depends on correlation: assets that move together offer little protection, while assets that respond differently to the same conditions smooth returns.

Hypothetical example: a 60/40 portfolio when stocks fall 20% and bonds rise 5% returns 0.6 × (−20%) + 0.4 × 5% = −10%, half the stock loss. See asset allocation.