Diversification
Definition
The risk management strategy of spreading investments across different assets, sectors, geographies, and asset classes to reduce the impact of any single investment's poor performance.
Diversification is often called the only "free lunch" in investing. By holding a mix of assets that don't move in perfect lockstep, you can reduce portfolio risk without necessarily sacrificing expected returns. When one investment declines, others may hold steady or increase, smoothing your overall returns.
True diversification requires spreading across multiple dimensions: asset classes (stocks, bonds, real estate, crypto), geographies (US, international developed, emerging markets), sectors (technology, healthcare, energy, financials), and company sizes (large, mid, small cap). Simply owning 50 tech stocks is not well-diversified.
The correlation between assets determines diversification's effectiveness. Assets with low or negative correlation provide the most benefit. Historically, stocks and bonds have had low correlation — when stocks fall in a recession, bonds often rise as investors seek safety. Adding uncorrelated assets like real estate or commodities can further reduce portfolio volatility.
Over-diversification can also be a problem. Owning too many funds with overlapping holdings creates "diworsification" — added complexity without additional risk reduction. A portfolio of 3-5 broad index funds can provide excellent diversification with minimal overlap.
For crypto portfolios, diversification means not putting everything in one token, but the crypto market is highly correlated internally. A portfolio of 10 altcoins may feel diversified but could drop 80% together in a bear market. True diversification requires mixing crypto with traditional assets.
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Frequently Asked Questions
How diversified should my portfolio be?
A well-diversified portfolio for most investors includes US stocks, international stocks, bonds, and potentially real estate and alternatives. Three to five broad index funds can achieve this. The right mix depends on your age, risk tolerance, and financial goals.
Does diversification protect against all losses?
No. Diversification reduces unsystematic risk (risk specific to individual investments) but not systematic risk (broad market risk). In severe downturns like 2008, most asset classes declined. Diversification reduces the magnitude and frequency of losses but doesn't eliminate them.