What is diversification?
Don’t put all your eggs in one basket.
Rather than keeping money in one place, spread it across several — so that if one is damaged, you do not lose everything. Spreading is not, however, a promise that you will not lose.
In 30 seconds
- Diversification is summed up as “Don’t put all your eggs in one basket”: spreading money across different investments.
- It is based on the hope that if one loses money, others will make up for it. It is not a promise of no loss.
- Split $100 four ways and, if one part goes to zero, you lose $25. But if all four fall together, the loss is not reduced.
Not all in one basket.
Rather than keeping money in one place, spread it across several.
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What diversification is
The SEC’s investor site sums up diversification as “Don’t put all your eggs in one basket”: spreading your money among various investments.[1]
Spreading is not a promise.
Diversification rests on the hope that losses will be made up elsewhere.
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The word “hope”
The same page describes spreading money in the hope that if one investment loses money, the others will make up for those losses.[1] It is a hope, not a promise of no loss.
Split it four ways.
Spread the money, and if one part goes to zero, you lose only that part.
Amount lost if one of four $25 parts of $100 goes to zero (a worked example)
If all four fall together, the loss is not reduced.
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A worked example
Keep $100 in one place, and if it goes to zero you lose $100. Split it into four parts of $25, and if one goes to zero you lose $25 (our worked example).
But if the parts fall together, the loss is not reduced. What you spread across matters.
Spread across kinds of basket.
Shares, bonds, cash. Another approach is to spread across kinds of basket.
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Three categories
The SEC’s guide names stocks, bonds and cash as the most common asset categories.[2]
Spreading within one category, and spreading across categories themselves: diversification has two levels.
A scale for reading how you spread.
A scale for reading diversification.
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How many parts
How many parts the money is split into.[1]
Kinds of basket
Whether the parts are of the same kind or different kinds.[2]
Moving together
Whether the parts rise and fall together.
This is not advice
This edition explains the idea of diversification. It does not recommend any product or allocation.
Next question
NEXT QUESTIONA high yield casts a long shadow.NEXT QUESTIONA small owner of the company.See the Field Notes shelf →What this edition cannot tell you
- A recommended way to split or allocate. It differs from person to person and is not covered here.
- Research that measures how well diversification works.