Diversification, explained simply

The basic principle

If all your money is tied to one company, a bad year for that company can hit you hard. Diversification just means spreading your investments out so you’re not relying on one business or one thing going right.

Buying several companies in the same sector is not necessarily broad diversification. Businesses may react similarly to a common shock.

Different layers of diversification

Investors may look at exposure across companies, industries, countries, currencies and asset classes. The point is to understand what risks are shared. An investment fund may hold hundreds of securities and still be heavily exposed to a particular region or sector.

What diversification cannot do

A broad downturn can affect many investments at once. Diversification does not prevent loss or guarantee better performance. It helps address certain concentrated risks, rather than making market risk disappear.

How to inspect what you own

If you are researching a fund, read the issuer’s holdings information and product documents. Look beyond the fund name: identify the main regions, sectors, underlying companies, assets and any use of borrowing. Two different fund tickers may hold many of the same underlying assets.

Why two funds can be less diversified than they look

Imagine a hypothetical fund focused on large US technology companies and another broader US share fund. They have different names and may hold different numbers of shares, but many large technology businesses could appear in both. Owning both would not necessarily double diversification.

The relevant unit of analysis is the combined underlying exposure. Look through each product to identify where the same positions recur and how concentrated the combined holdings could be.

Asset classes behave differently

Shares, bonds, cash and property-linked investments may react differently to interest rates, economic conditions and market stress. They also carry different risks within their own categories. Even assets described as defensive can lose value under some conditions.

The goal of learning about diversification is not to create a formula that never loses money. It is to recognise the sources of uncertainty in a portfolio and the trade-offs involved in spreading them.

Check whether two funds really add variety

Open the holdings pages for two ETFs you're considering. Compare the largest companies, industries and countries. If both own much the same businesses, having two tickers won't spread your risk as much as it appears. Next, check whether both are almost entirely shares or whether they include other assets such as bonds.

This is why a broad fund can sometimes provide more diversification than a complicated collection of narrow funds.