Diversification
Spreading investments across weakly correlated assets to cut risk.
Finance’s only free lunch
Diversifying means spreading money across assets whose prices do not move together. Losses on one are cushioned by the others: portfolio risk falls faster than expected return. Harry Markowitz, Nobel laureate in 1990, formalised the idea in 1952.
Illustration: beyond about twenty stocks, only market risk remains.
What diversification does not do
It removes company-specific risk, not market risk: when the whole market falls, a 50-stock portfolio falls too. Protection requires spreading across asset classes (stocks, bonds, cash, gold), regions and currencies.
Individual volatility 30%, correlation 0.3
Worked example
Two assets that offset
- Asset A: +20% in good years, -10% in bad. Asset B: the opposite.
- Alone, each swings between +20% and -10%: lots of volatility.
- Half and half: +5% every year, whatever happens.
Same average return, zero volatility: the effect of a -1 correlation.
Common mistakes
- Holding ten funds that contain the same stocks.
- Forgetting that correlations rise in a crisis: everything falls together.
Notitia newsroom · education, not investment advice.