Diversification

Diversification is the practice of spreading an investment portfolio across many holdings whose prices do not all rise and fall at the same time. Its purpose is to reduce the risk that one bad outcome, such as a single company failing, does serious damage to the whole portfolio. Investors diversify across individual securities, industries and sectors, countries and whole asset classes.

Diversification works hand in hand with asset allocation, which sets how much goes into each asset class, and its mathematics was formalised by the economist Harry Markowitz in 1952. Pooled products such as a mutual fund or an exchange-traded fund exist largely to give small investors cheap diversification. In US fund law, "diversified" also has a narrower legal meaning under the Investment Company Act of 1940.

A street vendor who sells only umbrellas does well on rainy days and badly on sunny ones. One who sells both umbrellas and sunglasses has steadier takings: whatever the weather, something sells. The vendor has not made either product more profitable, but has made the daily income far less unpredictable.

Diversification does the same with money. Holding many investments that react differently to the same events means the bad days of some are partly offset by the good days of others. It cannot stop every loss, but it makes it much less likely that a single surprise wipes out a large share of savings.

Harry Markowitz's article "Portfolio Selection", published in the Journal of Finance in March 1952, showed that the risk of a portfolio depends not only on the risk of each holding but on how the holdings move in relation to each other, measured by correlation. Investors could therefore build portfolios with less risk for the same expected return. The idea became the core of modern portfolio theory, and Markowitz shared the 1990 Nobel Memorial Prize in Economic Sciences with Merton Miller and William Sharpe. Sharpe's later work split risk into two parts: specific (or idiosyncratic) risk tied to one company, which diversification can largely remove, and market risk, which affects all assets and cannot be diversified away. Exposure to market risk is measured by beta.

For a portfolio of two assets, risk is measured by standard deviation of returns, and the portfolio's variance is:

• $\sigma_p$ is the standard deviation of the portfolio; $\sigma_p^2$ is its variance.
• $w_1$ and $w_2$ are the shares of the portfolio in each asset (they add up to 1).
• $\sigma_1$ and $\sigma_2$ are the standard deviations of the two assets.
• $\rho$ is the correlation between the two assets, from $-1$ to $+1$.

Take a 50/50 split between a stock fund with $\sigma_1 = 20\%$ and a bond fund with $\sigma_2 = 10\%$:

• If $\rho = 1$ (they move in lockstep), $\sigma_p^2 = 0.25 \times 0.04 + 0.25 \times 0.01 + 2 \times 0.25 \times 1 \times 0.02 = 0.0225$, so $\sigma_p = 15\%$: simply the average, with no benefit.
• If $\rho = 0$ (unrelated), $\sigma_p^2 = 0.01 + 0.0025 = 0.0125$, so $\sigma_p \approx 11.2\%$.
• If $\rho = -0.5$ (partly opposite), $\sigma_p^2 = 0.0125 - 0.005 = 0.0075$, so $\sigma_p \approx 8.7\%$, lower than either asset on its own.

The expected return is the same 50/50 average in all three cases; only the risk changes, which improves the risk–return trade-off. That is the sense in which diversification is often called the only "free lunch" in investing, a phrase usually attributed to Markowitz's work.

• Within an asset class. Owning many companies across sectors rather than a few. A fund tracking the S&P 500 holds about 500 large US companies in one product.
• Across asset classes. Combining shares, bonds, cash and sometimes property or commodities, whose returns have different drivers.
• Across countries and currencies. Reducing dependence on one economy or one central bank.
• Across time. Investing gradually, as with dollar cost averaging, spreads the risk of buying everything at a peak.

Under Section 5(b)(1) of the US Investment Company Act of 1940, a fund may call itself "diversified" only if, for at least 75% of its assets, no more than 5% of total assets is in any one issuer and it holds no more than 10% of any issuer's voting shares. Funds that do not meet the test must say they are non-diversified. In the EU, UCITS funds follow the similar "5/10/40" spread rule.

Correlations tend to rise in crises. In 2008 most risky assets fell together, and in 2022 US stocks and bonds both lost ground, so portfolios were less protected than historical data suggested and volatility rose across the board. Over-diversification ("diworsification", a term popularised by fund manager Peter Lynch) can leave a portfolio so broad that it simply mirrors the market while paying higher fees, such as a larger expense ratio. Concentrated investors, including some followers of value investing, argue that a few well-researched holdings can beat a broad spread. Diversification also cannot remove market-wide risk: in a deep bear market, a diversified portfolio still falls, though usually by less.

• The Nobel Prize: Harry M. Markowitz, facts
• U.S. Securities and Exchange Commission: Beginners' Guide to Asset Allocation, Diversification, and Rebalancing