Diversification

What it does

Owning many unrelated investments means no single failure can dominate your outcome. If one holding of thirty goes to zero, the damage is contained; if it was your only holding, it is not.

Diversification has dimensions

Counting holdings is the weakest measure of diversification.

• Across companies
• Across sectors and industries
• Across geographies
• Across asset classes
• Across time, through regular contributions

The limits

Diversification cannot protect against a broad market decline, because in a severe downturn most things fall together. It also reduces the effect of being unusually right about one holding — that is the trade.

Counting holdings versus mixing different kinds of assets

Thirty stocks spread company-specific risk, but they are still thirty stocks: in a broad decline most of them tend to fall together. Mixing asset types that respond to different things is what changes how deep a broad decline can go.

Hypothetical allocation example: in a year when stocks fall 30% and high-quality bonds rise 2%, a $10,000 portfolio of 100% stocks ends at $7,000 (−30%). A 60/40 mix ends at $6,000 × 0.70 + $4,000 × 1.02 = $4,200 + $4,080 = $8,280 (−17.2%). The mix still lost money. In other years (2022 is a real example) stocks and bonds fell together, so this cushion is not guaranteed.

A hypothetical comparison

Hypothetically, consider two $10,000 portfolios: one entirely in a single company, the other spread across thirty unrelated companies of similar quality. If one company in the concentrated portfolio failed completely, the entire $10,000 would be affected. If one company in the diversified portfolio failed completely, roughly one-thirtieth of the portfolio would be affected, all else equal. This is illustrative arithmetic, not a projection of what any actual portfolio will do.