Why diversify? The math of concentration risk

A holding’s weight decides how much its fall can hurt. The portfolio loses the weight times the fall: 70% × 50% = 35%, while 5% × 50% = 2.5%. A single company can fall that far on one bad earnings report, a lawsuit or a fraud, and some never come back.

Concentration cuts both ways: a portfolio heavy in one winner can beat a diversified one for years. Diversification gives up the chance that your best idea carries everything in exchange for not letting your worst idea ruin everything. The recovery math explains why many investors accept that trade: a 35% loss needs a 54% gain just to break even. The risk management guide applies the same logic to trading.

Concentration risk
The risk that one holding, sector or asset type is so large that its fall alone causes a serious loss.
Diversification
Spreading money across investments that react differently to events, to reduce the damage any single one can do.

What is correlation in investing?

Correlation measures how much two investments tend to move together, on a scale from +1 to −1. High correlation means they usually rise and fall at the same time; low correlation means their moves are mostly unrelated; negative correlation means one tends to rise when the other falls.

Diversification works through low correlation, not through the number of holdings. In the drawing below, two assets that move together give a 50/50 mix that swings almost as much as each one. Two assets that often move in opposite directions give a mix that swings less, even though each is just as jumpy on its own.

Correlations are not fixed. In sharp sell-offs and bear markets, many stocks fall together, just when diversification is wanted most. And ten technology stocks are ten holdings but largely one bet.

Correlation
A measure from +1 to −1 of how closely two investments move together. Lower correlation gives more diversification.

Turn your phone sideways to read the drawing. Tap to close.

Two hand-drawn panels with asset A (solid line), asset B (dashed line) and their 50/50 mix (thick green line). Left, move together (high correlation): the three lines zigzag in step, and the note reads the mix swings almost as much. Right, move in opposite directions (low or negative correlation): A zigs while B zags, the green mix line is much smoother, and the note reads the mix swings less.

How to diversify: across stocks, sectors and asset types

Think in layers. Each one protects against a different kind of surprise:

  • Companies: enough holdings that no single company dominates. One broad index fund holds hundreds.
  • Sectors: technology, healthcare, energy, financials and others react differently to the economy; see stock market sectors.
  • Styles and sizes: large and small companies, growth and value stocks.
  • Regions: US and non-US markets.
  • Asset types: stocks, bonds or sukuk, cash and others behave differently. Investors who follow Sharia screening often use sukuk and screened funds; see halal stock investing.
  • Time: adding money gradually, as in dollar-cost averaging.

How many stocks do you need? Diversification vs over-diversification

Adding holdings cuts company-specific risk quickly at first, then less and less, as the drawing below shows. What remains is market risk: the risk that the whole market falls, which no number of stocks in that market removes.

Past a point, more holdings add little protection and more work. Sixty individual stocks you cannot follow, or five funds that all own the same large companies, is over-diversification: it looks spread out but behaves like one index, with more costs and paperwork. Check what your funds actually hold before adding another.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn curve of ups and downs (risk) against the number of different holdings: the red curve drops steeply from few holdings and then flattens just above a dashed floor; the shaded area above the floor is labeled company-specific risk shrinks, the gray band below it market risk stays, and a note reads past a point, more holdings add little and are harder to follow.

What is rebalancing? A worked example

The parts of a portfolio grow at different speeds, so the mix drifts away from what you chose. Rebalancing means selling some of what grew and adding to what lagged, to return to the target.

Hypothetical, drawn below: $10,000 with an example target of 60% stocks and 40% bonds ($6,000 and $4,000). After a year, stocks are up 40% to $8,400 and bonds down 10% to $3,600: $12,000 in total, now 70/30. Rebalancing sells $1,200 of stocks and buys $1,200 of bonds, back to $7,200 and $4,800. Without it, the portfolio would carry more stock risk than planned.

Common approaches are rebalancing on a calendar, such as once a year, or when a weight drifts past a band, such as five percentage points, and steering new money to the underweight part instead of selling. Selling can trigger costs and taxes. The 60/40 mix is only an example: the right mix depends on each person’s goals, time horizon and tolerance for losses.

Rebalancing
Selling part of what has grown and buying what has lagged to bring a portfolio back to its target mix.
Asset allocation
How a portfolio is divided among asset types such as stocks, bonds or sukuk, and cash.

Turn your phone sideways to read the drawing. Tap to close.

Three hand-drawn stacked bars with green stocks and hatched gray bonds: start, $10,000 split $6,000 (60%) and $4,000 (40%); after a year, $12,000 split $8,400 (70%) and $3,600 (30%); rebalanced, $12,000 split $7,200 (60%) and $4,800 (40%). Between the last two, notes read sell stocks $1,200 and buy bonds $1,200, and a small note says example target, not a recommendation.