Diversification
You now know the risk types. Diversification is the first and most important tool for managing them, but it only works against certain risks.
What Is Diversification?
- Diversification means spreading investments across different asset classes, sectors, industries, and geographies
- The goal is to reduce the impact of any single investment's poor performance on the overall portfolio
- It is the primary strategy for reducing non-systematic (diversifiable) risk
Exam Tip: Gotchas
Diversification addresses non-systematic (diversifiable) risk only; the single most frequently tested point on this topic.
How Diversification Works
- A well-diversified portfolio holds securities that are not perfectly correlated
- When one investment goes down, another may hold steady or go up, cushioning the blow
- Correlation measures the degree to which two investments move together:
- Correlation of +1.0 = perfect positive correlation (move in lockstep); no diversification benefit
- Correlation of 0 = no relationship; moderate diversification benefit
- Correlation of -1.0 = perfect negative correlation (move in opposite directions); maximum diversification benefit
Exam Tip: Gotchas
Holding many securities in the same sector (e.g., 50 tech stocks) does NOT give real diversification. True diversification requires assets with low correlation, not just different tickers.
Asset Allocation
- Asset allocation is the practical implementation of diversification
- Dividing a portfolio among different asset classes: stocks, bonds, cash, real estate, commodities, etc.
- Each asset class responds differently to market conditions, providing natural diversification
Exam Tip: Gotchas
Asset allocation is the practical implementation of diversification across asset classes (stocks, bonds, cash, etc.); it is not a separate concept from diversification, it is how diversification is applied.
What Diversification Does and Does NOT Do
| Diversification... | Explanation |
|---|---|
| Reduces non-systematic risk | Company-specific events affect only a small portion of the portfolio |
| Does NOT eliminate systematic (market) risk | Broad market declines affect all securities |
| Requires low correlation | Holding 50 tech stocks is NOT true diversification |
| Benefits increase with variety | Cross-sector, cross-geography, cross-asset class |
Exam Tip: Gotchas
- Diversification eliminates non-systematic risk ONLY. It does NOT protect against market-wide downturns (systematic risk).
- To hedge systematic risk, investors use options, inverse ETFs, or other hedging instruments.
- This is one of the most frequently tested distinctions on the SIE.
Diversification sets the initial risk level. But over time, market movements can throw a portfolio out of balance. That's where rebalancing comes in.