Definition
Diversification is spreading money across different assets whose prices do not move perfectly together, so that a large loss in one holding has a smaller effect on the whole portfolio.
How it works
The idea depends on correlation, a measure from −1 to +1 of how closely the returns of two assets move together. When holdings have low or negative correlation, losses in some tend to be partly offset by others, so the portfolio swings less than its parts. Adding many assets that move almost identically adds little.
Diversification reduces specific risk, the risk tied to one company or one project, such as a failed product, a fraud or a hack. It does not remove market risk, the risk that hits almost everything at once, such as a recession or a sharp rise in interest rates. Index funds and ETFs are common ways to hold many companies through a single product.
Correlations are not fixed. They tend to rise during crises, when many assets fall together just when diversification is needed most. In crypto, many coins tend to move closely together, so owning several coins can be far less diversified than it looks. Diversification also has a cost on the upside: the best performer carries less weight in a spread-out portfolio.
Example (hypothetical numbers)
Suppose you have $10,000 and Company X's shares fall 60% after a problem specific to that company.
If all $10,000 is in Company X, the loss is $10,000 × 60% = $6,000.
If the money is split evenly across 10 companies and only Company X falls, the loss is $1,000 × 60% = $600, or 6% of the portfolio.
If a market-wide fall instead drops every holding by 30%, both portfolios lose $10,000 × 30% = $3,000.
Spreading the money limited the damage from one company's problem, but not from a fall that hit everything at once.
Common mistakes
- Owning many coins or stocks that move almost identically and calling it diversified.
- Expecting diversification to prevent losses in a market-wide fall.
- Assuming correlations measured in calm periods will hold during a crisis.
Related calculators
This glossary is for education only and is not investment advice. Examples use hypothetical numbers.