Diversification: don't put all your eggs in one basket

“Don’t put all your eggs in one basket” is ancient advice. In investing, it has a precise and mathematically demonstrable meaning: spreading investments across assets that do not move in perfect lockstep reduces the volatility of the overall portfolio without necessarily reducing its expected return.

Nobel Prize winner Harry Markowitz called diversification the only free lunch in investing. The phrase captures something real: you can reduce risk by spreading your holdings, and in doing so you are not necessarily accepting a lower return as the cost of that risk reduction.

What diversification actually does

To understand diversification, consider two assets. Asset A returns 10% in good years and -5% in bad years. Asset B also returns 10% in good years and -5% in bad years, but its good and bad years are the opposite of Asset A’s. If you hold only Asset A, your returns fluctuate between 10% and -5%. If you hold equal parts of A and B, the good years of one offset the bad years of the other, and your combined return is approximately 2.5% per year — lower volatility, different expected return depending on the correlation.

In practice, assets rarely have perfectly inverse relationships, but the principle holds directionally: combining assets with low or negative correlation reduces volatility. The correlation coefficient between two assets, ranging from -1 (perfect inverse) to +1 (perfect lockstep), is the key variable. Assets with correlations below +0.5 provide meaningful diversification benefit when combined.

Diversification across assets

The foundational level of diversification is across asset classes: equities, bonds, real estate, commodities and cash.

Each asset class has different return drivers and responds differently to economic conditions. Equities perform well during economic growth, tend to suffer during recessions. Bonds often appreciate during recessions when interest rates fall and investors seek safety. Real estate tends to be a partial inflation hedge. Commodities can perform well during inflationary periods.

A portfolio holding only equities is more volatile than one that also holds bonds, because there is no offsetting asset during equity drawdowns. The trade-off is that bonds have lower long-term expected returns, so a more diversified multi-asset portfolio may grow more slowly in the long run. The appropriate balance depends on the time horizon and risk tolerance established in chapter 5.2.

Diversification across geographies

Within equities, holding only one country is a significant concentration of risk.

A portfolio invested only in UK equities is exposed to UK-specific risks: a recession driven by domestic factors, a currency crisis, a political disruption, a sector-specific downturn affecting industries concentrated in the UK. Any of these could produce poor returns for UK equities while global markets perform well.

A globally diversified equity portfolio — using something like a MSCI World or FTSE All-World index fund — distributes this risk across dozens of countries and currencies. No single country’s underperformance can significantly damage the whole portfolio.

The United States represents approximately 60-65% of developed market indices, reflecting the size and dominance of US companies globally. Some investors choose to hold additional exposure to other regions (Europe, Asia Pacific, emerging markets) to reduce US concentration. Others are comfortable with the market-cap weighting of global indices. Both approaches are defensible.

Diversification across sectors

Within equities, sector concentration is another source of avoidable risk.

An investor heavily weighted toward technology companies did extremely well in 2020-2021 and poorly in 2022. An investor concentrated in energy did the opposite. An investor concentrated in financial stocks did poorly in 2008 and then well in the recovery. Sector-specific risks — regulatory changes, commodity price swings, technological disruption — can dramatically affect individual sectors while broad markets are unaffected.

A broad market index fund automatically provides sector diversification, because it holds companies across all sectors in proportion to their market capitalisation. An investor selecting individual stocks or sector funds creates concentration risk that requires active management.

The limits of diversification

Diversification reduces idiosyncratic risk — the risk specific to individual companies, sectors or countries. It cannot eliminate systematic risk — the risk of the entire market declining simultaneously.

In the financial crisis of 2008, virtually all equity markets fell significantly, regardless of geography or sector. In the COVID-19 shock of March 2020, diversification within equities provided limited protection because everything fell at once. Correlation between equity markets and between equity sectors increases dramatically during market panics, precisely when investors most want the protection.

The hedge against systematic risk comes from holding asset classes that genuinely diversify against equities — primarily high-quality government bonds, which tend to appreciate when equity markets fall sharply due to flight-to-safety flows.

The practical upshot: diversification within equities (across geographies and sectors) is important and largely free. The more significant decision is the split between equities and bonds (or other non-correlated assets), which determines your exposure to systematic market risk.

A globally diversified, multi-asset portfolio does not guarantee positive returns in any given year. It does significantly reduce the probability of catastrophic outcomes, which is the goal.