The Myths Of Diversification

A Deep Dive on Diversification

Diversification is protection against ignorance. It makes little sense if you know what you are doing.

- Warren Buffet -

Diversification.
We have talked about this before in a couple of our older articles. Still, it is one of those topics that never stops sparking debate. That is why I wanted to bring it back under the microscope today.

This time the approach will be different. In the past we shared tips and a practical guide that stayed more on the qualitative side. Today I would like us to go a little deeper.

We have grown as investors, and so have you. Together we are ready to take this conversation to the next level.

It is not only about what you do, but also about why you do it. Markets shift constantly. What felt right six months ago may look very different today. That is why understanding the mechanisms behind diversification, not just the results, can be such a powerful exercise.

And believe me, there is much more to diversification than first meets the eye.

So grab a coffee, get comfortable, and let us dive into the myths of diversification.

The Mechanism

Intuitively, the idea seems simple: spread your risk across more assets. And in a sense, that is correct. But it is not the whole story. There is one crucial condition to this principle, often left implied rather than stated outright.

Before revealing it, let’s use an example. A bit of imagination first makes the theory easier to grasp before we apply it to the real world.

Picture a small village with only two shops, each represented by its own stock. The entire market consists of these two stocks. The first is Wet Weather Co., a family-run business that sells umbrellas. The second is SPF Studio, a shop that specializes in sunscreen.

In this simple setup, the market is perfectly balanced. When one stock rises by 5 EUR per share, the other falls by 5 EUR. The gains and losses cancel each other out exactly.

In more technical terms, these two stocks are perfectly negatively correlated. Their correlation is exactly –1. This means a portfolio holding only these two stocks cannot lose money, but it also cannot make money. Safe, but dull.

Now imagine the opposite. If the two stocks had a correlation of exactly +1, their prices would move together in lockstep. Every gain would be doubled, but so would every loss. Exciting, but risky.

The final case is the one with no correlation at all. Here, if stock A rises by 50 percent, stock B could move either up or down in a completely unrelated way. In finance, this is called having independent returns, and it is precisely what investors are looking for.

The lower the correlation between assets in a portfolio, the lower the overall risk becomes, while the expected return remains the same. This is the real power of diversification. It is not simply about holding a large number of assets. The key lies in holding assets that have little or no correlation with one another.

The Myth Of Risk Mitigation

Let us take two real-life market examples and break them down in terms of diversification.

The first is the concept of beta, often used as a measure of risk among investors. Those familiar with the Weighted Average Cost of Capital (WACC) will know beta, since it is used to calculate the Cost of Equity for a stock.

In essence, beta is a measure of how a stock moves relative to the market. The calculation itself is a little different from a simple correlation, but the idea is similar. It measures how sensitive a stock is to market movements, in terms of volatility. Whether or not this is always the best approach is open for debate.

A beta higher than 1 means the stock tends to move more than the market, making it riskier and more volatile. A beta lower than 1 means the stock tends to move less than the market, and is therefore considered safer.

In practice, this can guide portfolio construction. If you want an aggressive portfolio, you would select stocks with beta above 1. If you prefer a defensive approach, you would look for stocks with beta below 1. And if you want to go even further and build a counter-cyclical portfolio that rises when the market falls, you would select stocks with a negative beta.

A second example is exchange-traded funds, or ETFs. These are often seen as the ultimate form of diversification. But does that assumption still hold?

Consider the most popular index in the world, the S&P 500. At first glance it looks highly diversified, but there are two important caveats. First, it is not geographically diversified. The index is made up entirely of US stocks. If the US economy were to enter a severe crisis, the index would inevitably fall with it. That is not a flaw, since by design the S&P 500 represents the 500 largest US companies by market cap, but it is worth remembering.

Second, the index is very top-heavy. Because the S&P 500 is weighted by market capitalization, the largest companies exert the most influence. Today, the top 10 holdings account for about 40 percent of the index, which means the other 490 stocks together only drive the remaining 60 percent.

The key, as we discussed earlier, is correlation. If those top 10 holdings had low correlations with each other, diversification could still be strong. But in reality, nearly all of them are technology companies. That means their sector exposure is highly correlated. A shock to the tech sector could deal a heavy blow to passive investors who believe they are well diversified simply by owning the index.

And it does not stop there. The largest of them all, Nvidia, depends heavily on the others for its revenues. The current race for artificial intelligence has tied Nvidia’s growth closely to the investments of the other big tech players. If those investments slow down or fail to deliver returns quickly enough, Nvidia’s revenues could take a hit. That creates even more correlation, which is the opposite of what you want in a supposedly safe, passive ETF.

A Simple Approach

Research has not yet reached a clear conclusion on what the best approach to diversification is. Still, based on the articles and papers I have read so far, I want to share a few sensible guidelines.

The first principle is to keep it simple. One strategy often considered in research is called naive diversification. Its premise is straightforward: spread your money equally across all investments. If you hold ten assets, you allocate ten percent to each of them.

Some studies have shown that naive diversification is not always the most optimal strategy, though these conclusions usually depend on specific assumptions and caveats. But its greatest strength remains its simplicity. And in practice, simplicity often wins. Even if complex models suggest you might squeeze out a few percentage points more return, the cost in time, effort, and potential errors may not be worth it.

Another frequently debated question is the size of a portfolio. How many assets should an investor hold to be perfectly diversified, meaning returns are maximized while risk is minimized?

Again, there is no definitive answer. A common rule of thumb is around ten to fifteen assets. In my view, fifteen already feels like a lot. Risk, to me, is not knowing what you are doing. And if you own fifteen stocks - remember, though, that assets are not limited to stocks - you are responsible for following fifteen companies.

That means reading thirty quarterly reports, fifteen half-year reports, and fifteen annual reports. It means performing fifteen qualitative analyses and fifteen quantitative valuations. And even then, you cannot be sure your portfolio is truly optimized.

There is also the risk of over-diversification. If you hold too many uncorrelated stocks, your portfolio may start to replicate the market itself. You would end up with market-level returns and market-level risk, but with the added burden of higher transaction costs and greater effort to maintain. Hardly the dream scenario for an investor.

Closing Remarks

At the end of the day, diversification is not about blindly spreading your money across as many assets as possible. It is about being intentional. The key lies in understanding correlations, keeping your strategy simple, and making sure you truly know what you own.

There will never be a one-size-fits-all answer. Some investors thrive with broad index funds, others prefer a smaller set of carefully chosen stocks. What matters most is that your portfolio reflects your own goals, risk tolerance, and capacity to follow through.

So keep it simple, stay mindful of what you hold, and remember that true diversification is as much about clarity as it is about numbers.

Thanks for reading.

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Please note: This article includes a disclaimer regarding investment advice.

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