construction
Diversification is the only free lunch
The rule
Hold things that do not rise and fall together, and you lower risk without lowering your expected return. It is the closest thing to a free lunch in investing.
Where it flips
Diversification stops being free when it becomes owning fifty things that secretly share one driver. Or so many names that nothing can help. That is fake spreading and false comfort. The fix is to spread across real, different risks, not across labels that all move as one.
When two holdings do not move up and down at the same time, their bad days partly cancel out. So the combined swing is smaller than the average of the parts. The best part is that this smoothing does not cost you expected return. It comes from the low link between them. That is why spreading across truly different drivers is rewarded in a way almost nothing else is.
A worked example
A reader holds five 'different' stocks that are all private banks. They are shocked when all five fall together on one worry about interest rates. Adding holdings driven by unrelated forces would have cut the portfolio's swing by near ₹50,000 on such a day, without cutting its expected return. [illustrative]
How to spot it
- ·many holdings that all share one sector or one driver
- ·the link between holdings ignored while names are counted
- ·'diversified' claimed from labels, not from behaviour
- ·positions that all fall on the same piece of news
Harry Markowitz · Portfolio Selection