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Unsystematic and systematic risk
Diversification is one of the main talking points in conversations around investment advice. Ever since markets have become more accessible, there has been a strong emphasis on the importance of having a diversified portfolio, but what is diversification, and how can it really be achieved?
Everyone knows that risk is an inevitable part of investing, after all, there are no free lunches. Typically, when choosing investments we're exposed to two types of risk: unsystematic (also called idiosyncratic) and systematic. The first is firm-specific risk, it can be the risk associated with unfavourable litigation, a natural catastrophe that impacts a company's headquarters, and so on. The second is market risk, and it relates to the degree to which an investment moves with the overall market.
Building a diverse portfolio
This is the part where diversification comes into play. In essence, diversifying a portfolio means spreading investments across several different assets to help manage both types of risk (though, as we'll see, it doesn't do so equally).
By holding a portfolio of, say, thousands of stocks, each with a relatively low weight, you reduce the impact of any single company-specific event. If one holding suffers a bad outcome, it's unlikely to have a meaningful effect on the performance of your overall portfolio. This is diversification doing what it does best: eliminating unsystematic risk almost entirely.
With systematic risk, things are not as linear. This is the risk inherent to being exposed to the market itself, it’s driven by broad forces like interest rates, inflation, or recessions that touch nearly every asset to some degree. You can combine asset classes that have historically had low or negative correlation (i.e. whose returns haven't historically moved in the same direction and to the same degree) to smooth out the overall volatility of your portfolio. However, this won’t entirely erase systematic risk as historical correlations are not a fixed law.
Stocks and bonds are the clearest recent example. Historically, both these asset classes had an inverse relationship, with the long-term return correlation between equities and bonds having been broadly negative since the 1990s. However, that changed in 2022, with that year representing the first time that both equities and bonds had experienced negative returns in the same year since 1977. While some data shows this inverse relationship partially resuming in 2023, this is still a reminder that historical correlations between asset classes aren't a fixed law and can shift with the macro environment.
Common diversification mistakes to avoid
While diversification is a crucial strategy for managing investment risk, investors should watch out for a few common pitfalls:
- Over-diversifying. Spreading money across too many funds with overlapping holdings doesn't add much protection (it might just increase investment cost and complexity, without meaningfully reducing risk any further).
- Mistaking "different" for "uncorrelated." Real diversification means choosing assets that don’t move in the same direction at the same time. For example, buying gold, silver, and platinum might look like variety, but because these metals often behave similarly, they don’t provide the kind of diversification investors usually aim for.
- Skipping rebalancing. Portfolios drift as some holdings grow faster than others. Without periodically rebalancing back to target weights, a portfolio can end up far more concentrated and far riskier than originally intended.
Also don't forget that you can diversify by spreading your investments across various industries (like technology, health care, energy, and financials), across several geographical regions, market capitalizations, investment styles, and so forth.
Bottom line
Diversification is a core approach to managing investment risk and supporting long‑term growth. While it doesn’t guarantee profits or eliminate losses, building a well‑diversified portfolio can help reduce the impact of market ups and downs and lead to more stable returns over time.
https://www.justetf.com/en/academy/diversification-protects-your-portfolio.html
https://www.fca.org.uk/investsmart/diversification
https://www.fidelity.com/viewpoints/investing-ideas/guide-to-diversification
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