Diversification, the only genuinely free lunch

Diversification is the only thing in finance that genuinely gives you something for nothing: less risk, at no cost in expected return. But it only works if the things you own are actually different, and most portfolios that look diversified are not.

Why it works

If you own one stock, your fate is its fate. Own twenty, and a disaster at one is an inconvenience rather than a catastrophe. That much is obvious. What is not obvious is that the benefit depends almost entirely on correlation: the degree to which your holdings move together.

The floor you cannot cross

Drag the correlation slider up and something important happens: the curve flattens against a floor. No matter how many stocks you add, risk stops falling. That floor is systematic risk, the risk of the market itself. Recessions, wars, rate shocks: these hit everything at once, and no amount of diversification within equities will save you from them.

What diversification kills is specific risk, the risk that this particular company burns down. That is worth killing, because the market does not pay you for taking it. You are not compensated for the risk of holding a single stock, because you could have avoided it for free.

The market pays you for risk you cannot avoid. It pays you nothing for risk you chose not to diversify away.

Fake diversification

• Owning twelve tech companies is owning one bet, twelve times. In a sector sell-off they fall together, and correlation approaches 1 exactly when you need it not to.
• Owning eight funds that each hold the same mega-caps is diversification in name only. Look at what is inside them, not how many tickers you hold.
• Correlations rise in crises. Assets that looked unrelated for a decade discover they are all correlated at precisely the wrong moment. Plan for that.