Investiční slovník
Diversification: What It Really Means and Why It Is the Foundation of Every Portfolio
Key takeaways
- Diversification reduces non-systematic risk — that is, the risk associated with a specific company or sector, not with the market as a whole.
- The key is not the number of assets but their low correlation: assets that do not fall at the same time genuinely protect the portfolio.
- A global ETF fund can diversify across thousands of companies in a single purchase — that is the main strength of the passive approach.
- Excessive diversification (diworsification) dilutes returns without further reducing risk — more is not always better.
- Time diversification through regular investing (DCA) protects against poor timing.
Diversification is the strategy of spreading investments across multiple different assets so that the loss or decline of one position does not threaten the entire portfolio — it rests on the principle that different assets do not fall at the same time for the same reason.
Why diversification works: correlation as the key
The foundation is not the number of stocks but their mutual correlation. A correlation of 1 means two assets move in exactly the same way — such "diversification" does not help. A correlation of 0 or negative means the assets move independently or even in opposite directions — that is real protection.
An example: adding ten technology stocks to a portfolio instead of one diversifies very little, because the technology sector generally falls all at once. Adding bonds, commodities, or equities from other regions diversifies far more effectively.
Two components of risk
Portfolio theory distinguishes:
- Non-systematic risk — specific to a company or sector (poor results, scandal, bankruptcy). Diversification eliminates this risk.
- Systematic risk — market risk that affects all assets simultaneously (recession, pandemic, interest rate shock). Diversification does not eliminate this; it only redistributes it to varying degrees.
A global ETF fund covering thousands of companies practically eliminates non-systematic risk. Systematic risk cannot be avoided — it is the price of investing.
Practical diversification for a Czech investor
Global equity ETFs (MSCI World, FTSE All-World) diversify across thousands of companies in dozens of countries in a single purchase. Adding a bond ETF reduces overall portfolio volatility, since historically bonds and equities do not always fall at the same time.
Geographic diversification is particularly important in the Czech Republic — the domestic market (Prague Stock Exchange) is too small to suffice on its own. How to build a first portfolio that truly diversifies is shown in the first portfolio guide.
Time diversification: DCA
Diversification is not only about what you buy but when. Regularly investing a fixed amount regardless of price — DCA or cost averaging — protects against poor timing. You invest both when the market is expensive and when it is cheap, and average out the entry price.
FAQ
What is diversification in simple terms?
Spreading money across different investments so that a decline in one does not threaten the entire portfolio. The core idea is that different assets do not fall at the same time for the same reason — and this low correlation protects the portfolio.
How many stocks do I need for good diversification?
Studies show that 20–30 randomly selected stocks from different sectors eliminate most non-systematic risk. A global ETF fund handles this automatically across thousands of companies — and adds geographic diversification.
Does diversification protect against every loss?
No. It protects against non-systematic risk (a specific company's decline). Diversification does not prevent systematic market risk (recessions, crises) — in such times assets fall together. Only a combination of different asset classes can help.
Is it possible to diversify too much?
Yes — so-called diworsification. Adding more similar assets stops reducing risk and merely dilutes return. A portfolio of 200 highly correlated stocks is no better than 30 well-distributed ones.