Diversification
Do not put all your eggs in one basket: an old idea, but it only works if the baskets do not break together.
Why it works
If two investments do not always move the same way, the combined value swings less than the average of the individual swings. Expected return stays an average; risk falls.
Correlation
Correlation runs from -1 to +1. Near +1 the two move together (little protection); near 0 they are independent; negative means they tend to move in opposite directions.
Careful: in crises many correlations rise. Diversification protects least exactly when it is needed most.
Diversifying for real
Ten stocks in the same sector and country are not diversification. You diversify across sectors, regions, asset types (stocks, bonds, commodities) and over time.
There is also too much: many near-identical instruments add complexity without reducing risk.
In short
- Diversification reduces specific risk, not market risk.
- Correlation matters, not the number of holdings.
- In crises correlations tend to rise.
- Sector, region and asset type are the three main levers.
Check your understanding
Is owning five banks from the same country a diversified portfolio?
Show the answer: Barely: they share the same drivers (rates, national economy, regulation) and tend to move together.
Two instruments have a correlation of 0.95. What does the second add in terms of risk?
Show the answer: Almost nothing: it moves nearly like the first, so the protection is minimal.