MANYDiversified

How diversification reduces risk

Diversification works when your holdings don’t all move together. Correlation measures this on a scale from minus 1, where two assets move in opposite directions, to plus 1, where they move in lockstep. Combining assets with low or negative correlation smooths the ride, because losses in one are partly offset by steadier results in another.

Correlations are not fixed. High-quality bonds have often held up when stocks fell, but in 2022 U.S. stocks and bonds dropped together as interest rates rose. Many assets also tend to fall together in a panic, exactly when diversification is needed most.

Spread across and within asset classes

The main asset classes are stocks, bonds and cash, with real estate and commodities often added. Diversifying across them sets your overall level of risk. Diversifying within them protects you from the failure of a single company, industry, country or borrower.

• Stocks: mix company sizes, industries and countries, including markets outside the United States.
• Bonds: vary issuers, maturities and credit quality.
• Cash: keep emergency savings separate from long-term investments.
• Employer stock: limit it, since your paycheck already depends on that company.

Index funds as instant diversification

An index fund buys all or a representative sample of the securities in an index, so one purchase can spread your money across hundreds or thousands of companies. Broad index funds also tend to cost less to own than actively managed funds, and low costs compound in your favor over decades.

Look at what a fund holds, not just its name; its fact sheet lists the top holdings and their weights. Most stock index funds weight companies by market value, so the largest firms can make up a big share of the fund. Owning several funds that track similar indexes adds overlap, not diversification.

Rebalance to keep the mix you chose

Over time, winners grow into a larger share of your portfolio. A mix that started at 60 percent stocks and 40 percent bonds can drift toward 70 percent stocks after a long rally, quietly raising your risk. Rebalancing means trimming what has grown and adding to what has lagged.

Some investors rebalance on a calendar, such as once a year; others act when an asset class drifts past a set band, for example 5 percentage points from its target. In taxable accounts, selling can trigger capital gains, so steer new contributions toward the underweight assets or rebalance inside tax-advantaged accounts first.

What diversification can’t do

Risk comes in two kinds. Unsystematic risk belongs to a single company or industry, such as a failed product, a fraud or a lawsuit, and spreading your money widely reduces it. Systematic risk, such as a recession, an interest rate shock or a broad market crash, affects nearly everything at once, and no amount of diversification removes it.

So diversification doesn’t guarantee a profit or prevent losses in a falling market. Market-wide risk is managed instead through your asset mix, your time horizon and enough cash that you are never forced to sell in a downturn.

Concentration risk in a business

Companies face the same problem. If one client supplies 40 percent of revenue, that client’s decision to leave or demand lower prices becomes the company’s biggest risk, and buyers and lenders usually value such a business lower. Dependence on a single supplier, sales channel or advertising platform carries similar risk.

Track the share of revenue from your largest customers and channels every quarter, and note which contracts could end on short notice. Reducing concentration usually starts with winning more customers in the core business, before launching anything new.

Expanding without diworsification

When a company does diversify, related moves are usually safer. The Ansoff matrix, a long-standing strategy framework, separates selling more in existing markets, developing new products, entering new markets and full diversification into new products for new markets, the riskiest of the four.

Conglomerates that own unrelated businesses often trade for less than their parts would be worth separately, a gap known as the conglomerate discount, and breakups aim to close it. General Electric, for example, split into three separate public companies by 2024. Investor Peter Lynch popularized the term diworsification in his 1989 book One Up on Wall Street, where he spelled it diworseification and aimed it at companies that expand into businesses they don’t understand. The term now also describes portfolios padded with overlapping holdings.