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Diversification

Diversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.

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Exam Tip

Diversification reduces UNSYSTEMATIC (company) risk, NOT systematic (market) risk.

What is Diversification?

Diversification is the practice of spreading investments across different assets to reduce exposure to any single investment's risk. The principle is "don't put all your eggs in one basket."

Types of Diversification

TypeDescriptionExample
Asset ClassDifferent types of investmentsStocks, bonds, real estate
SectorDifferent industriesTech, healthcare, energy
GeographicDifferent regionsUS, Europe, Emerging markets
Company SizeDifferent market capsLarge, mid, small cap
StyleGrowth vs. valueGrowth stocks, value stocks

How Diversification Reduces Risk

When assets are not perfectly correlated:

  • Some go up while others go down
  • Portfolio volatility is reduced
  • Smoother returns over time

Key Concept: Correlation

  • Correlation of +1: Assets move together
  • Correlation of -1: Assets move opposite
  • Correlation of 0: No relationship

Systematic vs. Unsystematic Risk

Risk TypeDiversifiable?Examples
Unsystematic (Company)YesManagement issues, product recalls
Systematic (Market)NoRecession, inflation, interest rates

Modern Portfolio Theory (MPT)

Developed by Harry Markowitz, MPT shows that diversification can:

  • Reduce risk without reducing expected returns
  • Create an "efficient frontier" of optimal portfolios

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Related Terms

Asset Allocation

Asset allocation is an investment strategy that divides a portfolio among different asset classes (stocks, bonds, cash) based on an investor's goals, risk tolerance, and time horizon to optimize risk-adjusted returns.

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