Why Diversification Works

The plain answer

Diversification means spreading your money across many investments instead of depending heavily on a few. It works because different investments do not always rise and fall at the same time or by the same amount.

Diversification cannot prevent every loss. It reduces concentration risk, which is the risk that one company, industry, country, or investment type has an outsized effect on your results.

How it actually works

Each investment has risks specific to it. A company can lose a major customer, an industry can face new competition, or one country’s economy can weaken. Holding many investments limits the damage any single event can cause.

The relationship between investment returns is called correlation. Investments with less than perfect correlation move differently from one another. Combining them can make the overall portfolio’s returns less dependent on any one source.

Broad diversification can include companies of different sizes and industries, investments from multiple countries, and different asset classes. An asset class is a group of investments with similar characteristics, such as stocks or bonds.

What this means for you

Judge diversification by what you own underneath, not by the number of investment names you see. Several funds may hold many of the same companies and provide less diversification than they appear to.

Your mix should reflect your goals, time horizon, and risk tolerance. Diversification is a way to manage risk within that plan, not a reason to take more risk than you can accept.

Common mistakes

• Holding many investments that contain the same underlying assets.
• Putting too much money into your employer, favorite company, or one industry.
• Assuming diversification guarantees a positive return.
• Adding complex investments without understanding what risks they introduce.
• Changing your mix because one part of the market recently performed best.

Related pages

• Investing overview
• The order of operations for your money