Quick Answer
Diversification means spreading investments across asset classes, sectors, and geographies to reduce non-systematic risk. Low correlation between holdings matters most; owning many similar stocks in one sector is not true diversification. Diversification differs from asset allocation, which manages systematic risk instead of non-systematic risk.
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 divides a portfolio among asset classes: stocks, bonds, cash, real estate, commodities, etc.
- Each asset class responds differently to market conditions
- Asset allocation and diversification are related but distinct tools
- Diversification spreads holdings across many securities to reduce company-specific (non-systematic) risk
- Asset allocation spreads across asset classes and helps manage market (systematic) risk, which diversification alone cannot remove
Exam Tip: Gotchas
Asset allocation and diversification are not the same tool. Diversification reduces non-systematic risk by holding many securities. Asset allocation, together with hedging, helps manage systematic risk, which diversification cannot remove.
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 in a stock portfolio, investors can use index put options.
- 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.
What Should You Check on Exam Day?
- Can you explain why diversification reduces non-systematic risk but not systematic risk?
- Do you know why holding many stocks in the same sector is not true diversification?
- Can you state how correlation between investments affects diversification benefit?
- Do you know the difference between diversification and asset allocation?