Diversification changes which risks dominate
Diversification spreads exposure across assets that do not all respond in the same way. Owning shares in ten companies can reduce dependence on one company's results. But if all ten rely on the same industry, a single industry shock can still hurt much of the portfolio together.
Go deeper
Different names can share the same risk
A portfolio containing several companies is less dependent on the survival of any one of them than a portfolio containing only one. Yet the number of holdings does not fully describe how diversified it is.
Ten airlines may all be affected by a sharp rise in fuel costs. Businesses from unrelated sectors may respond differently to that same event.
The key relationship is how returns move together, often described using correlation.
- Company-specific setbacks may be diluted across several holdings.
- Shared economic shocks can affect many holdings at once.
Diversification can reduce some risks without eliminating the possibility of loss. Correlations can also change, particularly during market stress, so past differences in movement are not a guarantee of future separation.