What Is Diversification?

Diversification means spreading an investment across different asset types, sectors or regions instead of a single one. The goal is to reduce a portfolio's total volatility, so that when one holding does badly others can offset it. The everyday version of the idea is a familiar saying: don't put all your eggs in one basket. If that basket falls, every egg breaks; spread them across baskets and one basket falling does not wipe out the whole investment.

Why it reduces total volatility

Diversification works because different assets do not all move at the same time in the same direction. This is called imperfect correlation between holdings. While one asset falls, another may stay flat or rise, and at the portfolio level part of these moves cancel out. As a result the day-to-day swings of the portfolio can be smaller than the average swing of the individual assets. For the swings themselves see volatility.

Consider a simple example. A portfolio invested in only one sector, say banking, falls all together on news that shakes that sector. Spread the same money across banking, industry, technology and energy, and the impact of an event hitting one sector on the whole portfolio is diluted, because the other parts are not affected to the same degree. It is this logic of spreading, not the numbers, that is the essence of diversification.

There is an important distinction here: diversification is not a way to increase expected return, but a way to lower the volatility you endure for a given return objective. That is why it is a risk-management tool, not a promise of gain.

Which risk it lowers, and which it cannot

It helps to split risk into two parts.

• Firm- or sector-specific risk: events such as a single company's bad earnings report, a manager resigning, or one sector falling out of favour affect only that holding. As you spread across different companies and sectors, the impact of this kind of risk on the portfolio weakens; this is the part diversification can reduce.
• Systematic (market) risk: interest-rate decisions, inflation, currency moves or a broad economic crisis hit nearly all assets at once. No matter how much you diversify, you cannot escape this; it is the part diversification cannot remove.

In other words, diversification files down the risk that can be removed, but not the risk built into the whole market. In practice, adding different assets to a portfolio lowers total volatility quickly up to a point; but as firm-specific risk thins out, what remains is mostly systematic risk, and beyond that point adding more assets barely reduces the swings.

Why an investment fund is diversified by design

An mutual fund is by definition a basket that holds many securities rather than a single one. Buying into an equity fund instead of a single stock means automatically sharing a portfolio spread across dozens of companies.

This is not just a habit but a rule. The SPK Communiqué on Principles Regarding Investment Funds (III-52.1) requires funds to spread their portfolio within set limits. The best known is the single-issuer limit: as a rule a fund may invest at most 10% of its assets in the securities of one issuer (different ratios apply to some asset types). This structural rule keeps any fund from becoming overly dependent on a single company, so diversification is built into the fund by regulation.

Dimensions and limits of diversification

Diversification is not one-dimensional. It is usually considered along these axes:

• Asset class: different types such as equities, bonds/bills, gold, foreign currency and deposits.
• Sector: different lines of business such as banking, industry, technology and energy.
• Geography: domestic and foreign, different countries and currencies.
• Maturity: a mix of short- and long-term debt instruments.

A fund-of-funds (fund of funds) takes the idea one step further: by holding other funds instead of individual securities, it diversifies across funds. This way you are spread across both different management approaches and different asset classes at once.

But diversification has an honest limit. It lowers risk, it does not zero it; in a bad market a diversified portfolio can still lose value. It is also possible to overdo it: adding many similar assets stops reducing risk beyond a point and only makes the portfolio hard to follow. Overlap — two funds that look different holding the same large companies — can create hidden concentration. To see how diversification shows up in a portfolio's past swings and drawdown, the terms risk value and maximum drawdown are helpful.