Definition
Diversification is the "only free lunch in finance"—it reduces portfolio risk without reducing expected return by combining assets with imperfect correlations. Unsystematic (company-specific) risk is virtually eliminated with 25-30 uncorrelated stocks. However, systematic (market) risk cannot be diversified away. Effective diversification requires genuinely different risk exposures, not just many holdings.
lightbulb Example
A portfolio of only tech stocks has 25% annual volatility. Adding healthcare, utilities, and consumer staples stocks (with 0.3-0.5 correlation to tech) reduces portfolio volatility to 15% while maintaining expected returns.
verified_user Key Points
- Reduces unsystematic risk without reducing expected return
- Requires imperfect correlations between assets
- 25-30 stocks eliminate most stock-specific risk
- Cannot eliminate systematic (market) risk