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Diversification is a familiar idea, and an often misunderstood one. Owning many positions is not the same as being diversified.
What matters is not how many things you own, but how differently they behave.
What diversification is
Diversification, in the SEC’s words, is the practice of spreading money among different investments to reduce risk. Its guide explains why it can work: “By including asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can protect against significant losses.”
The SEC adds that a diversified portfolio should be diversified at two levels: “between asset categories and within asset categories.”
Correlation in plain words
Correlation describes how closely two prices tend to move together. FINRA explains the high end of the scale: when investments are highly correlated, “what happens to one investment is likely to happen to the others.” At the other end are prices that move independently, or in opposite directions.
Diversification lives at the low end. Ten positions that respond to the same news behave like one large position. Two that respond to different forces really do spread the risk.
Where concentration hides
FINRA defines concentration risk as “the risk of amplified losses that may occur from having a large portion of your holdings in a particular investment.” It can build up without anyone choosing it:
- Success: one holding, or one kind of asset, does so well that it grows to dominate the account. FINRA’s example is a bull market that leaves stocks a much larger share of a portfolio than before.
- Similarity: several positions in the same industry, region or type of security, which FINRA says tend to move together.
- Overlap: individual companies held alongside a fund of the same kind of company. FINRA’s example is technology stocks next to a technology fund.
The SEC’s answer for investors is rebalancing: “bringing your portfolio back to your original asset allocation mix.” For a trader, the equivalent is a limit on how large any one position, or any group of related positions, may grow.
Why diversification weakens in a crash
Correlations are not fixed. Ontario’s securities regulator says diversification “becomes less effective in extreme market conditions”, with the 2008 financial crisis and the 2020 COVID-19 pandemic as recent examples, and that when a market crash happens, “the prices of most investments drop.”
The S&P 500 fell 57% from 2007 to 2009, and 34% in 33 days in 2020. In falls like these, positions that seemed unrelated can drop together, just when diversification is needed most.
Diversification reduces risk; it does not remove it. “You can’t eliminate risk from your portfolio,” the same regulator says, “but diversification can help reduce it.”
Diversification for a trader
For an active trader, diversification is less about owning many things and more about not letting one force decide everything. In practice that can mean spreading across:
- Markets: positions driven by different forces, rather than many versions of one bet.
- Time frames: not every position exposed to the same day’s news.
- Methods: rules that do not all depend on the same market condition, such as a strong trend.
Related positions still count together against the plan’s risk limits. Diversification spreads risk; it does not excuse more of it.
The takeaway
Diversification works when positions behave differently, and it weakens when everything falls together. Measuring exposure by how positions move, not by how many there are, shows the real risk in an account.
A written system builds this in, with limits on related positions decided before the market tests them.
Your results will depend on your own decisions, your capital and market conditions, and you can lose money.
