Lesson 7 of 10
Diversification and concentration
Different labels do not necessarily mean different underlying risks.
The idea
Diversification spreads exposure across holdings and types of assets. It can reduce the influence of one holding’s outcome, but it does not guarantee a gain or prevent a broad market loss.
Look through product names to the underlying holdings and drivers. Two funds may own many of the same companies. Ten stocks in one industry may react similarly to the same event. Counting account names alone is not a useful measure of diversification.
Worked example
Original illustration: A $10,000 example portfolio puts $5,000 into company A and $5,000 into company B. If A falls 40% while B is unchanged, the total falls $2,000, or 20%. A portfolio wholly in A would lose 40%. If both companies fall 40%, splitting the money between them does not help in this scenario.
| Scenario | Company A | Company B | Portfolio change |
|---|---|---|---|
| A falls; B unchanged | −40% | 0% | −20% |
| Both fall together | −40% | −40% | −40% |
A common mistake
Assuming that adding another fund automatically removes concentration.
Try it yourself
An example portfolio is 25% in A and 75% in B. A loses 20% and B is unchanged. What is the portfolio change, ignoring fees and rebalancing?
Show the worked answer
0.25 × −20% + 0.75 × 0% = −5%.