Diversification: why owning more companies lowers your risk

Diversification means spreading your money across many investments so that no single one can sink you. It’s the closest thing investing has to a free lunch: you reduce risk without necessarily reducing expected returns.

Why it works

Individual companies can collapse — through fraud, bad products, competition or simple bad luck. A whole market of thousands of companies is far less likely to. If you own 2,000 companies and one goes to zero, you lose 0.05% of your portfolio.

Three layers of diversification

1. Across companies: own many, not a handful.
2. Across countries and sectors: a single country or sector can lag for decades. Japan’s stock market took more than 30 years to regain its 1989 peak.
3. Across asset types: shares, bonds and cash behave differently. Bonds and cash usually fall less in a crash, which can make the ride easier to stick with.

The hidden concentration in popular indexes

Even broad indexes can be concentrated. Large US technology companies make up a big share of the S&P 500 and of world indexes weighted by company size. And the US itself is a large part of most world indexes. That’s not necessarily bad, but you should know what you own.

How to diversify simply

• One fund: a global (all-world) equity ETF covers thousands of companies in dozens of countries.
• Two funds: a developed-markets ETF plus an emerging-markets ETF, in the proportions you choose.
• Add stability: a bond ETF or savings for the part of your money you may need sooner or can’t bear to see fall.

Diversification isn’t…

• Owning ten tech stocks. That’s one bet in ten pieces.
• Owning five ETFs that track nearly the same index. Check the overlap.
• A guarantee. In a global crash, almost everything falls together for a while. Diversification limits permanent damage; it doesn’t remove short-term drops.

The short version

Own many companies, across many countries, and match the riskiness of the mix to how long you can leave the money invested.