Diversification: not putting all your eggs in one basket

Diversification means spreading money across many different investments, so that a problem with any one of them does only limited damage. It is the investing version of the old saying: don’t put all your eggs in one basket.

Why it works

Different investments don’t all move together. One company loses a big customer while another wins one; one industry has a bad year while another has a good one. When you hold many investments, some of these ups and downs cancel each other out, and the overall result swings less than any single holding does.

The key idea is how closely things move together. Owning ten oil companies is less diversified than owning ten companies in ten different industries, because the oil companies tend to rise and fall on the same news (the oil price).

The layers of diversification

Spreading money can happen on several levels:

• Across companies. One company can go bankrupt and its shares can fall to zero. If it is one of hundreds you hold, the damage is small.
• Across sectors. A sector is a group of companies in the same line of business, such as banks, energy, healthcare or technology. Sectors react differently to the same news: higher interest rates can help banks while hurting property companies.
• Across countries and regions. Economies grow at different speeds and face different problems. Investing abroad also brings currency risk: if you hold US shares and the dollar falls against the euro, your investment is worth fewer euros, even if the shares did not move. See exchange rates explained.
• Across asset types. An asset type (or asset class) is a broad family of investments: shares, bonds, cash, property and others. They respond differently to the economy. Bonds and shares, for example, have often moved in different directions, but not always: in some years both have fallen together.

A single fund that holds hundreds of companies, such as an index fund or ETF, diversifies across companies in one step. Whether it also spreads across sectors and countries depends on the index it follows.

What it can and can’t do

Diversification can	Diversification can’t
Limit the damage from one company failing	Stop the whole market from falling
Smooth out the ups and downs of single holdings	Guarantee a profit or protect against losses
Reduce reliance on one country, sector or currency	Remove the effect of a global recession or crisis
Make results depend less on luck in picking	Make a risky asset type safe

Risks tied to one company or industry can be spread away. Market risk, the risk that affects almost everything at once, cannot. In a broad market crash, such as during the 2008 financial crisis, most share markets around the world fell at the same time. A diversified portfolio of shares still fell; it just avoided the extra damage of being concentrated in the worst-hit companies.

Diversification reduces the risk of a bad surprise from one place. It does not reduce the risk of the market as a whole.

Hidden concentration

Being diversified on paper is not always the same as being diversified in practice. Many indices are weighted by company size, so a handful of very large companies can make up a big part of the total. Two funds with different names may hold many of the same shares. And a portfolio of many investments that all depend on the same thing, such as one country’s economy, may be less spread out than it looks.

How much diversification suits someone depends on their goals and situation; a regulated adviser is the person to ask. For how risk and potential return relate, read risk and return.