Why diversification works
When assets are not perfectly correlated — when they don’t all go up and down together — combining them in a portfolio reduces overall volatility. If your portfolio holds 100% in one stock, a 50% company-specific decline (CEO scandal, product failure, industry disruption) causes a 50% portfolio loss. If that stock is 2% of a 50-stock portfolio, the same event causes a 1% portfolio loss. The company-specific ("idiosyncratic") risk is diversified away. What remains — market risk, economic cycles, interest rate movements — affects all stocks and cannot be diversified away. This is "systematic" or "market" risk.
Dimensions of diversification
Across stocks: 20–30 stocks across different companies substantially eliminates company-specific risk. Across sectors: banks, technology, energy, healthcare, and consumer goods have different economic sensitivities — a recession that crushes banks may leave healthcare stable. Across geographies: UK, US, European, Asian, and emerging market stocks have different drivers; geopolitical events affecting the UK don’t necessarily affect Japanese markets. Across asset classes: bonds tend to perform differently from equities; property, commodities, and infrastructure add further diversification. A global all-world index fund provides all four dimensions simultaneously in a single product.
Diversification does not eliminate risk
In a severe global crisis (2008, March 2020), correlations between assets rise sharply — everything falls together. Diversification provides less protection exactly when you most want it. This is the limitation of correlation-based portfolio construction: correlations are not stable, and they tend to spike toward 1.0 during market crises. Truly defensive assets in a crisis tend to be government bonds of the most creditworthy nations (US Treasuries, UK gilts) and, sometimes, gold — which maintain their value or rise when equities fall.
“The only investors who shouldn’t diversify are those who are right 100% of the time.” — Sir John Templeton
What this means for you
If you hold a global index fund, you are already well-diversified across thousands of stocks and dozens of countries. If you hold individual stocks, aim for at least 20–30 positions across different sectors, and consider whether your total portfolio has meaningful exposure to different geographies and asset classes. The most common diversification mistake is what looks diversified but isn’t — five UK bank stocks are not diversified; they are highly correlated and all exposed to the same economic and regulatory environment. True diversification requires genuinely different exposures, not just more names.