Diversification only works below correlation 1.0
A portfolio of 20 stocks in different sectors has less risk than 20 stocks in the same sector, even if each stock’s individual volatility is identical. Diversification reduces risk only when correlations are less than 1.0.
Which portfolio risks you can diversify away
| Risk Source | What It Captures | Can You Diversify It? |
|---|---|---|
| Market (systematic) | Broad market movements | No — affects all stocks |
| Sector | Industry-specific factors | Yes — diversify across sectors |
| Idiosyncratic | Company-specific events | Yes — add more holdings |
| Factor | Value, growth, size, momentum exposures | Only by balancing factor exposures |
Check whether your holdings share hidden risk
List your top 5 holdings. Are they in different sectors with different risk factors? Or are they all tech stocks that will move together in a downturn? True diversification requires uncorrelated risk sources.
Name diversification versus factor diversification
Your portfolio has 15 positions across ‘different’ stocks, but 12 are high-growth tech companies. Are you diversified?
Correlations spike exactly when you need diversification
Finding the dominant source of portfolio risk
A portfolio's total risk is 22%. Decomposition shows 10% from AAPL (one position, ~40% weight), 6% from market-beta, 4% from sector exposures, 2% noise. What's the biggest opportunity to reduce risk?
Check your understanding
Sit with the ideas.
A portfolio holds 20 stocks equally weighted at 5% each. Stock A has a beta of 2.1 and a correlation of 0.85 with the rest of the portfolio. Stock B has a beta of 0.7 and a correlation of 0.15 with the rest. Which stock contributes more to total portfolio risk?
Why: