Many investors believe that owning many stocks automatically means low risk. This common misconception leads to portfolios that appear diversified but still carry significant risk. The truth is that diversification only reduces risk when your investments don't all move together.
True diversification requires understanding correlation—how your stocks move relative to each other. When stocks move in sync, diversification benefits disappear, and your portfolio risk remains high despite the number of holdings.
Correlation measures how stocks move together. When correlation is high, stocks rise and fall together, eliminating diversification benefits. For example, owning 20 technology stocks might seem diversified, but if they all respond similarly to market conditions, your portfolio risk is still high.
During market downturns, highly correlated stocks fall together, creating concentrated losses. This is why sector concentration matters—owning many stocks in the same sector doesn't provide true diversification.
Even with many holdings, concentration risk can dominate your portfolio. If a single stock or sector makes up too much of your portfolio, that position drives your overall risk regardless of how many other stocks you own.
For example, a portfolio with 30 stocks might seem well-diversified, but if one stock represents 40% of the portfolio, that position controls a large portion of your risk. True diversification requires both many holdings and balanced weights.
Diversification effectively reduces risk when you hold investments that respond differently to market conditions. This means spreading across sectors, asset types, and geographic regions, not just owning many stocks in similar companies.
Effective diversification includes:
When stocks move independently, losses in one area can be offset by gains in another, reducing overall portfolio volatility.
Many investors focus on the number of holdings as a measure of diversification, but this misses the bigger picture. Owning 50 technology stocks isn't more diversified than owning 10 stocks across different sectors.
What matters is the quality of diversification—how your holdings interact, not just how many you own. A well-constructed portfolio with 10 diverse holdings can be less risky than a portfolio with 50 correlated stocks.
Some correlations aren't obvious. For example, many stocks are correlated with the overall market, meaning they move together during market-wide events. ETFs can also create hidden correlations—if you own individual stocks and an ETF that contains those same stocks, you're more concentrated than you think.
A portfolio risk calculator reveals these hidden relationships, showing you where your real risk comes from and whether your diversification is working as intended.
To build truly diversified portfolios, focus on correlation and concentration, not just the number of holdings. Spread across sectors, balance your weights, and include positions that respond differently to market conditions.
Monitor your portfolio risk regularly to ensure your diversification is working. As positions grow or shrink, your risk profile changes. Regular rebalancing helps maintain effective diversification over time.
See if your diversification is working effectively by measuring your portfolio risk.
Use the Portfolio Risk Calculator →