Diversification explained: spreading risk across investments

Diversification is the practice of spreading money among different investments so that the result does not depend on any single one. The Securities and Exchange Commission's investor education site sums it up with a familiar phrase: "Don't put all your eggs in one basket." This post explains what that means in practice, where diversification helps, and where it does not.

The basic idea

Every investment carries some risk, meaning uncertainty about what it will be worth later. Some of that risk belongs to one company: a product fails, a lawsuit lands, management makes a bad decision. If a person's savings sit in the stock of one company, that company's troubles become the person's troubles.

Owning many investments changes the picture. One company's bad year matters much less when it is one of hundreds of holdings. The SEC describes the goal this way: if one investment loses money, the hope is that others make up for it.

Diversification does not remove risk. It changes the kind of risk a person carries, from "this one thing could fail" toward "the market as a whole could fall."

Two levels of diversification

The SEC's page on asset allocation and diversification describes two levels.

Across asset classes. An asset class is a broad category of investment, such as stocks, bonds and cash. These categories tend to respond differently to the same events. Conditions that hurt one may help, or at least not hurt, another. Dividing money among asset classes is called asset allocation, which is covered in asset allocation and rebalancing.

Within an asset class. Inside the stock portion of a portfolio, a person can hold many companies instead of a few, and companies in different industries, such as health care, technology and consumer goods. Inside the bond portion, a person can hold bonds from different issuers and with different maturity dates. Some investors also spread money across companies of different sizes and across countries.

How funds fit in

Buying hundreds of individual stocks and bonds is impractical for most people. Mutual funds and exchange-traded funds (ETFs) pool money from many investors and buy a portfolio of securities, so each share represents a small slice of many holdings. The SEC notes that these funds make it easy for investors to own a small portion of many investments.

A fund is not automatically diversified, though. A fund that invests only in one industry or one country concentrates risk in that area even if it holds dozens of companies. Someone using narrow funds may need several of them to reach a broad mix.

Target-date funds are one type of fund built to hold a diversified mix of stocks and bonds in a single investment.

What diversification cannot do

Three limits are worth understanding.

• It does not prevent losses. The SEC is direct about this: diversification cannot guarantee that investments will not suffer if the market drops. When markets fall broadly, a diversified stock portfolio falls too.
• It gives up the extremes. A portfolio of many holdings will not do as well as its single best holding. That is the cost of not doing as badly as its worst one.
• It does not address every risk. Inflation, interest rate changes and the need to sell at a bad moment are separate risks. The SEC's overview of investment risk describes several of them.

Common ways people end up less diversified than they think

Overlapping funds. Two funds with different names can hold many of the same companies. A person who owns four large-company stock funds may have much less variety than the number four suggests. The SEC suggests checking the top holdings of each fund to see whether they are actually different.

Employer stock. Some workplace plans offer the employer's own stock, and some employers make matching contributions in stock. An employee with a large holding has both a paycheck and savings that depend on the same company. The tax rules for employer stock are a separate subject, covered in company stock in a 401(k).

Accounts viewed one at a time. A person with an old 401(k), a current 401(k), an IRA and a spouse's accounts may have a sensible mix in each one and a lopsided mix in total, or the reverse. Diversification is a property of the whole picture, not of each account.

Drift. A mix that was balanced when it was chosen can become concentrated as some holdings grow faster than others. Rebalancing is the usual response.

Questions worth asking about a portfolio

• If the largest single holding lost most of its value, how much of the total would be affected?
• How much is in each broad asset class once all accounts are added together?
• Do the funds hold different things, or mostly the same things under different names?
• Is a meaningful share tied to one employer, one industry or one country?
• What does each fund cost? Holding many funds does not have to mean paying more, but it can. See fund fees and expense ratios.

Counting funds is not a measure of diversification. What matters is how different the underlying holdings are from one another.

A hypothetical illustration

Suppose two people each have $100,000. This is arithmetic only, not a forecast.

The first holds everything in one company's stock. If that stock falls by half, the account falls to $50,000.

The second holds 100 stocks in equal amounts of $1,000 each. If one of them falls by half and the others do not change, the account falls by $500, to $99,500.

The example also shows the limit. If all 100 stocks fall by 20 percent in a broad market decline, the second account falls to $80,000. Diversification protected against the single-company problem and did nothing about the market-wide one. Reducing exposure to market-wide declines is a question of asset allocation, not of how many stocks a person owns.