Diversification: what it can and cannot protect

Diversification is about risk drivers

Diversification spreads exposure so that one company, sector or economic event is less likely to determine the entire outcome. It cannot eliminate market losses, inflation risk or the possibility that many assets fall together during stress.

Counting holdings is only a starting point. Several funds may own the same large companies, and businesses in different industries may still depend on the same interest-rate, commodity or consumer-spending cycle.

Correlation changes

Correlation describes how returns have moved together over a measured period. It is not a permanent property. Relationships can strengthen in a crisis when investors seek liquidity or respond to the same macroeconomic shock.

Historical correlation should therefore be treated as evidence, not a guarantee. Scenario analysis can reveal shared exposures that a single statistic misses.

Concentration can be intentional

A concentrated position may reflect conviction, employer compensation or a successful holding that became large. The relevant questions are whether the size is understood, whether a loss would impair essential goals and whether taxes or trading restrictions limit rebalancing.

Diversification decisions should consider accounts together. A broad index fund in one account may duplicate sector funds or individual shares elsewhere.

• Measure position and sector weights across the whole portfolio.
• Include employment and property exposure in the risk discussion.
• Set review rules before a volatile market tests discipline.

Practical portfolio checks

List each holding’s main economic drivers, currency, geography, maturity and credit quality where relevant. Test scenarios such as recession, inflation, higher rates and a sharp currency move.

Rebalancing restores chosen weights but can create taxes and costs. A written range for each allocation can reduce emotional decisions while allowing normal market movement.