If you own one company and it fails, you lose everything you put in. If you own fifty companies and one fails, you lose a small part. That is in one sentence. It does not make you win more. It makes one mistake, one bad company or one bad country, much less able to hurt you.
Before we start: what do you think?
You split €1,000 equally across 50 companies. One of them goes bankrupt and its shares become worthless. How much do you lose?
✗ Only one of the 50 companies failed, so the other 49 parts are still there.
✗ Too much: each company got €1,000 ÷ 50 = €20, not €200.
✓ Right: each company got €20, so one total failure costs €20, which is 2% of the money.
✗ A company that goes bankrupt can really go to zero, so that €20 part is lost.
The risk of one basket
Even large, famous companies can fail. A product goes out of fashion. A new rival arrives. A manager makes a bad decision, or commits fraud. A whole industry can shrink. Each of these is a risk that belongs to one company or one industry, not to the whole market.
When all your money sits in one place, that one risk is your whole risk. When your money is split across many different companies, one failure becomes a small dent:
| How you split €1,000 | One company goes to zero | Loss in % |
|---|---|---|
| 1 company | −€1,000 | −100% |
| 10 companies, €100 each | −€100 | −10% |
| 50 companies, €20 each | −€20 | −2% |
A broad often holds hundreds or thousands of companies at once. That is one of the main reasons people use them. (See Index funds and ETFs.)
Quick check
What kind of risk does diversification reduce most?
Correlation in plain words
Owning many things only helps if they do not all move the same way. is the word for how much two things move together.
Think of two small shops on the same beach. One sells ice cream, the other sells umbrellas. On sunny days the ice-cream shop does well. On rainy days the umbrella shop does well. If you owned both, your income would swing less than with either one alone. They have low or negative correlation.
Now think of two ice-cream shops on the same beach. They do well and badly on the same days. Owning both doubles your business, but it does not calm the swings. They have high correlation.
In investing:
- Two companies in the same industry and the same country often move together.
- Companies in different industries and countries move together less.
- Different kinds of assets, such as , and cash, often behave differently from each other.
Worked example: Two investments that do not move together
You put €5,000 into investment A and €5,000 into investment B, €10,000 in total. In a bad year, A falls 30% and B rises 10%.
- A: €5,000 becomes €3,500 (−€1,500).
- B: €5,000 becomes €5,500 (+€500).
- Total: €9,000, a fall of 10%.
If you had put all €10,000 into A, you would have €7,000, a fall of 30%. The mix still lost money, but much less. Note that B also held you back in years when A rose fast. That is the price of a smoother ride.
Quick check
In your own words, what does high correlation mean?
What diversification cannot do
Diversification is powerful, but it has limits.
It does not remove market risk. When the whole economy is in trouble, most companies fall together. In a crash, investments that usually move separately can suddenly fall at the same time. A diversified investor still loses money in a bad year. They just avoid the extra risk of one company failing. (See Ups and downs.)
It does not help if everything is the same thing. Five funds that all hold the same large companies are not five baskets. They are one basket with five labels, and often five sets of fees. Check what the funds actually hold.
It can hide in your life outside investing. If you work for a company and also put your savings into that same company, your job and your money depend on the same thing. If it fails, you can lose both at once. The same is true if all your savings are in your home country's market and your income comes from there too.
Quick check
You own five different funds that all hold the same large companies. Are you well diversified?
Keeping the mix in shape
Over time, the part that rose fastest becomes a bigger share of your money. Imagine you start with €6,000 in stocks and €4,000 in bonds, a 60/40 mix. Stocks rise 25% and bonds do not move. You now have €7,500 in stocks and €4,000 in bonds. Stocks are now about 65% of the total, so you carry more risk than you planned.
means moving back to your planned mix, for example once a year. You sell a little of what rose, or put new money into what fell. It is a simple rule that makes you buy lower and sell higher without guessing.
This is education, not advice. The right mix depends on your goals, your time horizon and your country. Check your own situation.
Key takeaways
- Diversification means owning many different things, so one failure cannot do much damage.
- Split across 50 companies, one bankruptcy costs 2% of the money instead of 100%.
- Correlation is how much two things move together. Low correlation is what makes a mix calmer.
- Diversification does not remove market risk. In a crash, many things can fall together.
- Owning many funds that hold the same companies is not real diversification.
Try this
List everything you own that has a money value: savings, investments, pension, property, even your job. Next to each, write what could make it lose value. Then circle the items that would be hurt by the same event. Those circled items are one basket.