What Is Diversification?
Diversification means spreading money across many investments so that no single loss can do too much damage. What it protects against, what it can't, and how to tell whether you have it.
In one sentence
Diversification. Spreading money across many different investments so that one bad result has a smaller effect on the whole.
How it works
Owning many investments that don't all move together limits the damage any one of them can do. If one company fails, it's a small part of the whole.
| Portfolio | Amount in the failed company | Loss |
|---|---|---|
| One stock | $50,000 | $50,000, everything |
| 10 stocks, equal amounts | $5,000 | $5,000, a tenth |
| 50 stocks, equal amounts | $1,000 | $1,000, 2% |
What it can't do
Diversification reduces the risk of any one company or sector. It can't remove the risk of the whole market falling, which affects nearly everything at once. Mixing different kinds of assets, such as stocks and bonds, is how investors reduce that market-wide risk, which is Asset allocation. How a portfolio is divided among asset classes, such as stocks, bonds, and cash. More on this term.
Learn it properly
- Risk and ReturnPart 1: Foundations · Free