Every serious investor talks about diversification. Most people reduce it to "don't put all your eggs in one basket" and move on. But there's actual maths behind why it works — it's not just folk wisdom. Understanding that maths helps you build a portfolio that genuinely reduces risk rather than just feeling diversified.
If you own one stock and it falls 50%, your portfolio falls 50%. If you own two stocks and one falls 50% while the other rises 10%, your portfolio falls around 20%. The more holdings you add, the more the extreme moves of individual stocks average out.
But the key insight is that this only works if the stocks don't all move in the same direction at the same time. This is where correlation comes in.
Correlation measures how two investments move relative to each other, on a scale of -1 to +1:
Most stocks within the same market are positively correlated — they all tend to fall in a crash, they all tend to rise in a bull market. This is called systematic (or market) risk. No amount of stock diversification eliminates it.
What diversification does eliminate is unsystematic risk — the risk specific to one company. A pharmaceutical company's drug failing trials, a retailer's CEO resigning, a bank fraud. These events hit one company hard but barely move the broader market. Own 20 companies and one fraud can't sink your portfolio.
How many stocks do you need? Research suggests that owning roughly 20–30 stocks across different sectors and industries reduces unsystematic risk to near zero. Beyond that, you're not meaningfully reducing risk — you're just getting closer to owning the index. At which point, just own the index.
True diversification goes beyond just owning many stocks. Different asset classes have different correlations with each other:
| Asset class pair | Typical correlation | Diversification benefit |
|---|---|---|
| US stocks + UK stocks | ~0.7 (high) | Low — both equity markets |
| Stocks + government bonds | ~0 to -0.2 (low) | High — often move in opposite directions |
| UK stocks + property | ~0.3–0.5 | Moderate |
| Stocks + gold | ~0 to 0.1 | Moderate — gold uncorrelated over time |
| Stocks + Bitcoin | Variable, often 0.5+ | Lower than expected — correlates in crashes |
Owning only UK stocks exposes you to UK-specific risks — a UK recession, political instability, sector concentration (UK market is heavy on financials, energy, commodities). Global diversification smooths this out.
A global equity index fund like Vanguard FTSE All-World holds thousands of stocks across 49 countries. The UK accounts for about 4% of global market cap. Owning only UK stocks means ignoring 96% of the world's investable equity. Most investors are overly concentrated in their home country — this is called home bias, and it's irrational from a pure diversification standpoint.
You can own too many things. If you have 200 individual stocks, 15 sector ETFs, 8 bond funds, 3 property REITs, and some commodities, you've created an expensive, complicated portfolio that essentially tracks the global market anyway — but with far more complexity and often higher fees than just buying one global index fund. The goal is meaningful diversification, not maximum number of positions.
The simplest fully diversified portfolio: one global equity index ETF (80–90%), one global bond index ETF (10–20%), held inside an ISA. The equity fund gives you thousands of stocks across 49 countries. The bond fund gives you uncorrelated ballast. Both are cheap, both are liquid, both can be rebalanced once a year in 15 minutes. This genuinely beats most professionally managed portfolios over 20+ year periods. Complexity is not the same as sophistication.
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