Diversification
Diversification is the strategy of combining various investments to reduce unsystematic (idiosyncratic) risk without sacrificing expected returns.
Concept map
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Definition
Diversification is the strategy of combining various investments to reduce unsystematic (idiosyncratic) risk without sacrificing expected returns.
Use case
Used in portfolio management workflows, analysis, and technical interviews.
Judgment check
Useful only when the assumptions and inputs behind the metric are understood.
Deep dive
How to think about Diversification
The only free lunch in finance. As correlations between assets are rarely perfect (+1), combining them reduces portfolio volatility below the weighted average of individual volatilities. Modern Portfolio Theory (Markowitz) quantifies optimal diversification. Systematic risk (market risk) cannot be diversified away.
Example: Two assets each have 20% volatility and 10% expected return, with 0.5 correlation. A 50/50 portfolio has 17.3% volatility (not 20%) while maintaining 10% expected return. Adding more low-correlation assets further reduces risk.