Diversification is a way saying not putting all your eggs in one basket. In our article on risk, we talk about the risk of investing in individual securities, the idiosyncratic risk of an individual company’s ups and downs. By investing in many different companies, you reduce the idiosyncratic risk of your portfolio as the ups of one company balance out the downs of another. Once you have about 30 different individual companies in your portfolio, you have reduced most of your idiosyncratic risk.
But risk extends beyond individual companies. Companies in the same industry may be affected by regulation affecting their businesses in the same way. Or companies in the same country might be affected by economic downturns, monetary policy, or political risks like tariffs. In order to fully diversify your stock portfolio, you’ll want to include a variety of asset classes that further reduce the risk associated with investing in a particular place or industry. By including these asset classes that aren’t perfectly correlated with each other, the ups of one asset class balance out the downs of another just like diversifying with individual stocks does.
Taking it one step farther, different types of assets respond to changes in the economy or to policy in different ways. Some assets are more sensitive to changes in interest rates, some are more sensitive to inflation, and some are more sensitive to corporate tax rates. By diversifying across types of assets, you can further reduce the risk of investing in one asset class in particular. Your goal then should be to find the portfolio of assets that provides you with the minimum amount of risk for a given level of expected return. That’s the foundation of modern portfolio theory, which we cover in a bit more detail in this article.