Portfolio diversification

Diversification means spreading your money across many different investments, so that trouble at one company, industry or country does not decide the result of the whole portfolio. It is the only way to reduce risk without giving up expected return, which is why it is sometimes called the only free lunch in investing.

Risk you can diversify away, and risk you cannot

• Specific risk relates to a single company or industry: earnings, management, regulation. Diversification reduces it effectively.
• Market (systematic) risk affects the whole market: recessions, interest rates, crises. It does not go away no matter how many companies you hold.

Correlation is the key

Ten tech companies from one country make weak diversification, because they usually move together. Diversification works best when you combine assets with low or negative correlation: stocks with bonds, different regions, sectors and currencies. Bear in mind that correlations between stocks often rise during crises.

Common pitfalls

• Fake diversification: several ETFs that all hold the same largest companies.
• Currency concentration: the whole portfolio in a single foreign currency, such as the dollar.
• Over-diversification: so many positions that the portfolio becomes an expensive, hard-to-track copy of an index.