What Diversification Does and Doesn’t Protect

Two kinds of risk

Investment risk comes in two broad kinds.

The first is specific to one company, industry or country. A company can be mismanaged, a product can fail, an industry can be disrupted, or a single country’s economy can struggle. This kind of risk can wipe out an individual investment entirely.

The second affects almost everything at once. Recessions, rising interest rates and financial crises tend to pull most stocks down together.

Diversification is very effective against the first kind and much less effective against the second.

What it does well

If you own one company’s stock and it collapses, you lose most of that money. If you own a broad index fund holding hundreds or thousands of companies, one collapse barely registers. Owning many companies across many industries means that no single failure can do much damage.

The risk of concentration is easiest to see with employer stock. When Enron collapsed in 2001, many of its employees had much of their 401(k) savings in company stock. They lost their jobs and a large part of their retirement savings at the same time. That combination of income and savings depending on the same company is something diversification is designed to prevent.

What it doesn’t do

Diversification doesn’t prevent losses when markets fall broadly. During the financial crisis, the S&P 500 fell more than 50% from its October 2007 peak to its March 2009 low. A portfolio spread across hundreds of US stocks still lost about half its value at the worst point.

Spreading money across different types of investments, such as stocks and high-quality bonds, has historically helped soften those declines, because they don’t always move together. But relationships between investments can change, and in some periods stocks and bonds have fallen at the same time. Diversification reduces risk; it doesn’t remove it.

Owning many funds isn’t the same as diversification

It’s common to own several funds and assume that adds up to diversification. But if all of them hold large US companies, they may own largely the same stocks. Three funds that each track large US companies can leave you about as concentrated as one.

Meaningful diversification comes from owning things that behave differently: companies of different sizes, in different industries and countries, and different kinds of assets with different risks.

Checking your own

Start by looking at what your funds actually hold, not just their names. Fund fact sheets list their largest holdings and their mix of sectors and regions. If the same handful of companies appears at the top of every fund, you’re less diversified than it seems.

Look at how much of your net worth depends on one source. Employer stock, a single property or a business you own can all create concentration, especially if your income depends on the same thing.

Then think about time. Money you’ll need in the next few years is exposed to broad market declines in a way that money for decades from now isn’t. Diversification can’t protect short-term money from a market fall, but holding that money in cash or short-term bonds can.

The takeaway

Diversification protects you from any one investment, company or industry sinking your savings. It can’t protect you from the market as a whole falling, and owning many funds doesn’t guarantee it. The useful questions are what you actually own, how much depends on one source, and when you’ll need the money.

For more on how returns and losses combine over time, see why a good average return can still disappoint. The investment fee calculator shows what overlapping funds can cost if they charge higher fees for similar holdings.

Written by the Maxint Content team and reviewed by the Maxint Editor team. How we create our content

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This article is general education about US personal finance, based on the assumptions and sources described in it. It isn’t financial, tax or legal advice, and examples use hypothetical people and figures.