Diversification

Why this matters

Single companies fail far more often than whole markets. A portfolio that depends on a handful of companies can be badly hurt by one lawsuit, one failed product, or one fraud. Diversification is the main defense, and it's one of the few in investing that costs very little.

Two levels

The SEC's guide describes a diversified portfolio as spread at two levels: between asset categories and within them.¹

• Between asset classes. Holding stocks, bonds, and cash, as the last lesson showed. This is asset allocation.
• Within each asset class. Owning many different companies rather than a few, across different industries, sizes, and countries, and owning bonds from different issuers with different maturities.

The guide gives a street-vendor example: someone who sells both umbrellas and sunglasses has something to sell whatever the weather.¹ The goal is to own things that won't all have a bad day at the same time.

How many is enough?

The SEC's guide says that a stock portfolio of only four or five individual stocks isn't diversified, and that you'd need at least a dozen carefully selected stocks to be truly diversified.¹ That's a floor, not a target, and the stocks should come from different industries: twelve bank stocks are closer to one bet than twelve.

For most people, funds are the simplest route. A total stock market index fund, the guide notes, owns stock in thousands of companies.¹ Part 2's Index Funds covered how they work.

Two fictional investors each have $50,000 in stocks. One company they both own goes bankrupt, and its shares become worthless.

Portfolio	Share in the failed company	Loss from the failure	Share of the portfolio lost
Five stocks, equal amounts	$10,000	$10,000	20%
A fund of 500 stocks, equal amounts	$100	$100	0.2%

The failure is the same. Its effect on each portfolio differs a hundredfold. Diversification doesn't prevent bad outcomes; it keeps any single one from mattering much.

What diversification can't do

Some risks belong to one company or one industry: a product recall, a lost lawsuit, a new competitor. Owning many companies dilutes these. Other risks hit almost everything at once: a recession, a financial crisis, a sharp rise in interest rates. When the whole market falls, a portfolio of 500 stocks falls with it. In 2008, the S&P 500, a diversified index of large US companies, lost about 37% including dividends.²

That's why diversification within stocks isn't the whole answer, and why the last lesson's mix of asset classes matters too. The lesson Company, Sector, Market, and Liquidity Risk returns to this split between risks you can spread away and risks you can't.

Geography

Investing outside your home country adds companies and economies that may do well when your own doesn't. The SEC notes that international investing can spread risk across foreign companies and markets, and also lists special risks, including changes in currency exchange rates, less information about some companies, higher costs, and different levels of liquidity.³ Part 5 returns to currencies in Interest Rate, Inflation, and Currency Risk.

When more stops helping

Diversification has diminishing returns. Going from 5 holdings to 50 makes a big difference. Going from 50 to 500 makes much less. Beyond that, adding more usually brings problems instead:

• Overlap. Three different large-company funds may own mostly the same companies. You hold more funds without being any more diversified. Part 2's Types of ETFs showed how this happens.
• Fees. The SEC's guide warns that as you add investments, you'll likely pay more fees and expenses, which lower your returns.¹
• Complexity. A portfolio you can't explain is hard to monitor and hard to rebalance.

Key takeaways

• Diversify between asset classes and within them: across companies, industries, sizes, and countries.
• The SEC's guide says four or five stocks isn't diversified, and puts the minimum at about a dozen well-chosen ones. Broad funds can hold thousands.
• Diversification reduces company and industry risk. It can't protect against the whole market falling.
• Past a point, more holdings mostly add overlap, fees, and complexity.

Check your understanding

Which portfolio is most diversified?

1. Fifteen stocks, all of them regional banks in the same part of the country.
2. A broad stock index fund, a bond fund, and some cash.
3. Four different funds that each track large US technology companies.

A recession hits and most stocks fall. What did owning 500 different stocks protect against?

1. Very little in this case, since diversifying within stocks doesn't remove market-wide risk.
2. Most of the fall, because a large number of stocks always cancels out a recession.
3. All of it, because index funds are designed to hold their value in recessions.

What's next

Diversification works best when holdings don't move together. Correlation, Plainly explains how to measure that, and why stocks and bonds haven't always behaved the way people expect.