What is diversification in investing?
Diversification is the practice of holding a wide range of investments that don't all rise and fall at the same time. You spread money across many companies, industries, countries and types of asset, such as shares and bonds. The aim isn't the highest possible return. It's to avoid one bad result wrecking your plans.
It's the investing version of not putting all your eggs in one basket. The idea works because different investments react differently to the same events. A rise in oil prices might hurt airlines and help energy companies. A recession might hit shares hard while government bonds hold steadier. Hold a mix, and some of the damage in one place is offset elsewhere.
Most people now get diversification through funds rather than buying hundreds of shares one by one. A single global index fund or ETF can give you a slice of hundreds or thousands of companies in one purchase. Public money-guidance services commonly recommend spreading your money for the same reason.
Why does diversification reduce risk?
Diversification reduces risk because the damage from any single failure shrinks as each holding gets smaller. If one company makes up all of your portfolio, its collapse wipes you out. If it makes up one-twentieth, the same collapse costs you 5%. Spreading wider shrinks that loss further still.
Take two investors with $10,000 each, as an illustration. Investor A puts everything into one company. Investor B splits it equally across 20 companies, $500 each. Then one of those companies has a disastrous year.
The trade-off
Diversification works in both directions. If that one company had doubled instead, Investor A would have made $10,000 and Investor B only $500. You give up the chance of a spectacular win from one pick in exchange for a much lower chance of a disastrous loss. For money you're relying on, that's usually a good trade.
| What happens to one company | Investor A (1 company) | Investor B (20 companies) |
|---|---|---|
| Its shares fall 50% | Loses $5,000 (50%) | Loses $250 (2.5%) |
| It goes bust | Loses $10,000 (100%) | Loses $500 (5%) |
Illustrative figures that assume the other 19 companies are unchanged. In reality they would move too, up or down.
What are the main ways to diversify?
You can diversify across companies, industries, countries, asset types and time. Holding many companies limits single-firm risk. Spreading across sectors and regions limits damage from one industry or economy. Mixing shares, bonds and cash changes how far the whole portfolio swings. Investing gradually spreads the price you pay.
Watch out for hidden concentration close to home. If you work for a listed company and also hold its shares, your job and your savings depend on the same business. That's a risk worth reducing.
Across companies
Hold many companies rather than a few. A broad fund does this for you in one go.
Across industries
Technology, healthcare, banks, energy and consumer goods often respond differently to the same news. Avoid being heavily tied to one.
Across countries
Economies don't all grow or shrink at once. Investing only in your home market leaves you exposed to one country's fortunes.
Across asset types
Shares, bonds and cash behave differently. The mix between them, your asset allocation, sets how big your portfolio's swings are likely to be.
Across time
Investing a fixed amount each month means you buy at a range of prices rather than putting everything in at one moment. It doesn't guarantee a better result, but it reduces the risk of bad timing.
What can't diversification protect you against?
Diversification can't protect you from falls that hit almost everything at once. In a broad market crash, most shares drop together, and sometimes bonds fall at the same time too. It also can't remove currency risk, inflation or the effect of fees. It reduces risk. It doesn't eliminate it.
Investors call this market risk, or systematic risk: the part you can't diversify away. In the 2008 financial crisis, shares around the world fell sharply at the same time. In 2022, rising interest rates pushed down the prices of both shares and many bonds in the same year, which caught out people who assumed bonds would always cushion a fall.
There's also a point where more isn't better. Owning ten different global funds may feel diversified, but if they all hold the same large companies, you've added complexity and possibly cost without adding much spread. That leads to the next question.
Is one index fund or ETF diversified enough?
A broad global index fund is already well diversified across companies, holding hundreds or thousands of them. But it's weighted by company size, so the biggest firms and the largest national market make up a large share. It also holds only shares, so on its own it doesn't diversify across asset types.
That size-weighting matters. A global index fund puts more money into the most valuable companies, so a handful of very large firms can have a big influence on its returns. A single country's market makes up well over half of most global share indices by value. You still own many companies, but your result leans heavily on a few.
Overlap is the other trap. If you hold a global fund, a fund tracking that largest market and a technology fund, the same big names will appear in all three. Check each fund's top ten holdings on its factsheet to see how much they repeat.
How do you check whether your portfolio is diversified?
List everything you own, look inside each fund at its top holdings and regional split, and add up your exposure to single companies, countries and asset types. If any one company is more than a small slice of your total, or one region dominates, you're less diversified than you think.
A managed portfolio does most of this for you, including rebalancing. Our managed portfolio guide explains how that works.
List every holding
Include pensions, any tax-advantaged accounts your country offers, general investment accounts and any shares from your employer. Diversification is about your whole picture, not one account.
Look inside each fund
Open each factsheet. Note the top ten holdings, the split by region and sector, and the number of holdings.
Spot single-company exposure
Add up how much of your total sits in any one company, including through funds. Large single slices are where the real risk hides.
Check the asset mix
Work out your overall split between shares, bonds and cash. Compare it with the risk you decided you can take.
Rebalance if needed
If the mix has drifted, rebalance by adding new money to the underweight areas or selling a little of what has grown. Check any dealing costs, and in a taxable account any tax, before you sell.
How does the managed portfolio approach diversification?
The managed portfolio from the provider invests in a mix of funds, spread according to the risk level you're matched to. That gives you diversification without choosing funds yourself. It won't protect you from market-wide falls, and if you already hold a simple, well-spread portfolio you're happy to manage, you may not need it.
The the managed portfolio page shows what it invests in, and how it works explains how your portfolio is chosen and rebalanced. Read the risk disclosure for the risks that diversification can't remove, including currency movements and market falls.