Diversification, asset allocation and concentration risk
- Explain why diversification reduces risk
- Describe asset allocation
- Recognise concentration risk in a portfolio
Don’t depend on one outcome
Diversification means spreading money across investments that do not all move together. When one falls, others may hold up, so the whole portfolio swings less than its riskiest parts.
It works because company-specific surprises (a failed product, a lawsuit, a fraud) tend to cancel out across many holdings. This is called specific risk, and diversification can reduce it a lot.
What diversification cannot remove
Some risk hits almost everything at once: recessions, interest-rate shocks, financial crises. This market risk (or systematic risk) remains however many stocks you own.
Holding 30 technology stocks is not much diversification either; they often fall together. Spread across sectors, company sizes, regions and asset types.
Asset allocation
Asset allocation is how you split money between asset types such as stocks, bonds and cash. It drives most of a portfolio’s overall risk.
A portfolio of 80% stocks and 20% bonds will usually swing more and grow faster over long periods than one with 40% stocks and 60% bonds. The right mix depends on your time horizon and how much decline you can live with.
Concentration risk
Concentration risk is the danger of having too much in one holding, sector or theme. If 40% of your money is in a single company and it falls 50%, your whole portfolio drops 20% from that one decision.
Concentration often creeps in after a big winner grows. Rebalancing, trimming back to your target weights from time to time, keeps it in check.
Portfolio A holds 5 stocks at 20% each. Portfolio B holds 25 stocks at 4% each. One company falls 60% on bad news.
Portfolio A loses 20% × 60% = 12% from that single event. Portfolio B loses 4% × 60% = 2.4%. Same bad news, very different damage.
Key terms
- Diversification
- Spreading investments so that no single holding or risk dominates results.
- Specific risk
- Risk tied to one company or industry, which diversification can reduce.
- Market risk
- Risk that affects most investments at once and cannot be diversified away.
- Asset allocation
- How a portfolio is split between asset types such as stocks, bonds and cash.
- Concentration risk
- The risk of large losses from having too much in one holding, sector or theme.
- Rebalancing
- Adjusting holdings back to target weights after prices change.
- Sector
- A group of companies in a similar line of business, such as technology or energy.
Enter a sample portfolio in Portfolio Health and read its concentration and diversification notes.
Key takeaways
- Diversify across holdings, sectors and asset types.
- Diversification reduces company risk, not market risk.
- Asset allocation drives most of your overall risk.
- Watch for concentration creeping in after big winners; rebalance.