Two kinds of risk
Specific risk belongs to one company or sector, such as a failed product. Systematic risk hits the whole market, such as a recession. Diversification can greatly reduce specific risk but not systematic risk.
The role of correlation
Correlation measures how closely two assets move together, from -1 to +1. Combining assets with low or negative correlation reduces overall volatility more than combining similar assets. Stocks and high-quality bonds have often had low correlation, though not always.
Diminishing returns
Going from 1 stock to 20 removes a large share of specific risk. Going from 200 to 400 adds little. After a point, further risk reduction comes from adding different asset classes, not more of the same.
When correlations rise
During severe stress, many assets fall together. In 2022, both stocks and bonds fell as rates rose, a reminder that diversification benefits vary with conditions.
Key takeaways
- Diversification reduces company-specific risk, not market-wide risk.
- Low correlation between holdings is what makes it work.
- The benefit levels off, and correlations can rise in a crisis.