By the end of this lesson you understand what geographic diversification and sector diversification are, and why both are forms of the same idea.
\nThe previous lesson explained that diversifying is combining assets that don't all behave the same way in response to the same events. This lesson develops two specific dimensions along which that idea can be applied: the sector companies belong to and the geographic region they depend on.
\nSector diversification consists of not concentrating capital in companies from the same sector or industry. Companies in the same sector tend to share factors that affect them similarly -- a regulatory change, a rise in the price of a raw material they all use, a new technology displacing older ones. Spreading capital across companies in different sectors reduces how much a sector-specific event weighs on the portfolio.
\nGeographic diversification consists of not concentrating capital in assets that depend on a single geographic region or country. Assets tied to the same region tend to share factors specific to that region -- economic policy decisions, movements in its currency, already covered in Level 1, or local events. Spreading capital across different geographic regions reduces how much an event specific to just one of them weighs on the portfolio.
\nBoth are the same idea from the previous lesson, applied along different dimensions: they aren't two separate techniques, but two specific ways of combining assets that don't all behave the same way in response to the same events. In practice, some vehicles already covered in Level 1 -- an ETF or an investment fund -- bring together, within a single product, many companies from different sectors and geographic regions, so a single purchase can achieve, right from the start, broad spread on both dimensions.
\nA portfolio made up solely of companies from the same sector and the same country -- for example, several tech companies from the same local market -- remains highly concentrated despite including several different companies: an event affecting that sector or that country would hit them all at once. A portfolio with companies from different sectors and countries spreads that exposure better.
\nSector diversification spreads capital across companies in different sectors, and geographic diversification spreads it across different geographic regions -- both are specific forms of combining assets that don't all behave the same way in response to the same events, the same idea from the previous lesson applied to two dimensions.
\nWhy does a portfolio with several companies from the same sector and country remain poorly diversified?
\nWhy aren't geographic and sector diversification different diversification techniques, but the same idea applied to two dimensions?
","sortOrder":2,"readingMinutes":7,"difficulty":"Intermedio"},"previous":{"id":71,"moduleId":26,"slug":"why-does-diversifying-reduce-risk-without-proportionally-reducing-return","title":"Why does diversifying reduce risk without proportionally reducing return?","summary":"You understand why diversifying a portfolio reduces its risk without proportionally reducing expected return, and why diversifying reduces risk without eliminating it.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand why diversifying a portfolio reduces its risk without proportionally reducing expected return, and why diversifying reduces risk without eliminating it.\n\n## Content\n\nModule 1 introduced asset allocation: the decision of what percentage of a portfolio goes to each asset class. This lesson opens the next decision, within that allocation already made: how to spread the capital assigned to each class across several specific assets, instead of concentrating it in just one. This practice is called diversification.\n\nDiversifying is combining, in a portfolio, assets that don't all behave the same way in response to the same events -- when some fall, others don't fall to the same degree, or even rise. If all the capital assigned to stocks were in a single company, any problem specific to that company would hit the whole portfolio directly. If that same capital is spread across several companies that don't react the same way to the same events, a problem specific to one of them weighs less on the whole, because the others don't necessarily get affected the same way.\n\nThis explains why diversifying reduces risk without proportionally reducing expected return: the whole portfolio's expected return is, approximately, the combined result of the expected return of each asset that makes it up -- combining more assets doesn't reduce it on its own. Risk, on the other hand, does get reduced, precisely because the assets don't all move the same way: the drops in some and the rises in others tend to partly offset each other, and that offsetting smooths out the portfolio's overall swings more than the expected return lost by spreading the capital.\n\nIt's important to be precise about what diversification does and doesn't do: it reduces risk, it doesn't eliminate it. Part of the risk affects the market as a whole -- events that hit most assets at once, regardless of how many the capital is spread across. No allocation of capital within that same market eliminates that part of the risk completely.\n\n## Example\n\nTwo portfolios of the same size invest in stocks differently: one puts all its capital in a single company, and the other spreads that same capital across several companies that don't react the same way to the same events. If the first company runs into a specific problem -- a bad management decision, the loss of a major client -- the first portfolio suffers it in full. The second, not depending on a single company, is affected much more limitedly, although neither is protected against an event that affects the market as a whole.\n\n## Common mistakes\n\n- Thinking diversifying completely eliminates a portfolio's risk -- it reduces it, but part of the risk affects the market as a whole and no allocation of capital eliminates it.\n- Thinking diversifying also reduces expected return by the same proportion it reduces risk.\n\n## Summary\n\nDiversifying is combining, in a portfolio, assets that don't all behave the same way in response to the same events, which reduces the portfolio's overall risk without proportionally reducing its expected return. It reduces risk, it doesn't eliminate it -- part of it affects the market as a whole and no allocation of capital within it eliminates it completely.\n\n## Self-check\n\nWhy does combining assets that don't behave the same way in response to the same events reduce a portfolio's risk?\n\nWhy doesn't diversifying completely eliminate a portfolio's risk?","bodyHtml":"By the end of this lesson you understand why diversifying a portfolio reduces its risk without proportionally reducing expected return, and why diversifying reduces risk without eliminating it.
\nModule 1 introduced asset allocation: the decision of what percentage of a portfolio goes to each asset class. This lesson opens the next decision, within that allocation already made: how to spread the capital assigned to each class across several specific assets, instead of concentrating it in just one. This practice is called diversification.
\nDiversifying is combining, in a portfolio, assets that don't all behave the same way in response to the same events -- when some fall, others don't fall to the same degree, or even rise. If all the capital assigned to stocks were in a single company, any problem specific to that company would hit the whole portfolio directly. If that same capital is spread across several companies that don't react the same way to the same events, a problem specific to one of them weighs less on the whole, because the others don't necessarily get affected the same way.
\nThis explains why diversifying reduces risk without proportionally reducing expected return: the whole portfolio's expected return is, approximately, the combined result of the expected return of each asset that makes it up -- combining more assets doesn't reduce it on its own. Risk, on the other hand, does get reduced, precisely because the assets don't all move the same way: the drops in some and the rises in others tend to partly offset each other, and that offsetting smooths out the portfolio's overall swings more than the expected return lost by spreading the capital.
\nIt's important to be precise about what diversification does and doesn't do: it reduces risk, it doesn't eliminate it. Part of the risk affects the market as a whole -- events that hit most assets at once, regardless of how many the capital is spread across. No allocation of capital within that same market eliminates that part of the risk completely.
\nTwo portfolios of the same size invest in stocks differently: one puts all its capital in a single company, and the other spreads that same capital across several companies that don't react the same way to the same events. If the first company runs into a specific problem -- a bad management decision, the loss of a major client -- the first portfolio suffers it in full. The second, not depending on a single company, is affected much more limitedly, although neither is protected against an event that affects the market as a whole.
\nDiversifying is combining, in a portfolio, assets that don't all behave the same way in response to the same events, which reduces the portfolio's overall risk without proportionally reducing its expected return. It reduces risk, it doesn't eliminate it -- part of it affects the market as a whole and no allocation of capital within it eliminates it completely.
\nWhy does combining assets that don't behave the same way in response to the same events reduce a portfolio's risk?
\nWhy doesn't diversifying completely eliminate a portfolio's risk?
","sortOrder":1,"readingMinutes":7,"difficulty":"Intermedio"},"next":{"id":73,"moduleId":26,"slug":"how-much-diversification-is-enough","title":"How much diversification is enough?","summary":"You understand what criterion guides how much diversification is enough in a portfolio, without a single prescriptive figure.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand what criterion guides how much diversification is enough in a portfolio, without a single prescriptive figure.\n\n## Content\n\nThe two previous lessons explained what diversifying is and how to do it along different dimensions. This lesson closes the module with a pending question: is there a point where adding more assets stops helping?\n\nThe benefit of reducing risk by adding assets to a portfolio is large at first -- going from a single asset to several notably reduces the specific risk of depending on just one -- but that additional benefit gets smaller and smaller as more assets keep being added. Beyond a certain point, adding many more assets no longer reduces risk appreciably, because much of what's left is precisely the part of the risk that affects the market as a whole, already covered in this module's first lesson -- and no further allocation of capital reduces that.\n\nThere's no single figure that works for every portfolio. What does exist is a practical criterion: vehicles already covered in Level 1 -- an ETF or an investment fund -- can bring together, on their own, dozens or even hundreds of companies from different sectors and geographic regions, achieving broad spread with a single purchase, compared with building that same diversification by buying individual stocks one at a time. Adding positions that don't provide a genuinely different spread from what's already held -- for example, several companies very similar to each other -- adds complexity to the portfolio without appreciably reducing its risk.\n\nThis completes the module: diversifying a portfolio is combining assets that don't all behave the same way, along dimensions like sector and geographic region, up to a point where adding more assets stops providing an appreciable risk reduction. That portfolio composition is one of the elements revisited later, when building a real portfolio from start to finish.\n\n## Example\n\nAn investor who manually buys ten shares of similar companies within the same sector spends time and effort on limited diversification. Another investor who buys a single ETF with hundreds of companies from different sectors and countries achieves, with a single trade, a much broader spread than the first.\n\n## Common mistakes\n\n- Thinking more assets is always better, with no limit, ignoring that the additional benefit of adding more assets progressively shrinks.\n- Thinking diversifying requires buying dozens of individual stocks one at a time, instead of using vehicles like an ETF or an investment fund that already spread the capital on their own.\n\n## Summary\n\nThe benefit of reducing risk by adding assets to a portfolio gets smaller and smaller as more are added -- there's no single figure valid for every portfolio, but vehicles like an ETF or an investment fund let you achieve broad spread with a single purchase, without needing to accumulate similar assets that don't provide a genuinely different spread.\n\n## Self-check\n\nWhy does the benefit of adding more assets to a portfolio progressively shrink instead of staying constant?\n\nWhy can an ETF or an investment fund achieve, with a single purchase, broader spread than buying individual stocks one at a time?","bodyHtml":"By the end of this lesson you understand what criterion guides how much diversification is enough in a portfolio, without a single prescriptive figure.
\nThe two previous lessons explained what diversifying is and how to do it along different dimensions. This lesson closes the module with a pending question: is there a point where adding more assets stops helping?
\nThe benefit of reducing risk by adding assets to a portfolio is large at first -- going from a single asset to several notably reduces the specific risk of depending on just one -- but that additional benefit gets smaller and smaller as more assets keep being added. Beyond a certain point, adding many more assets no longer reduces risk appreciably, because much of what's left is precisely the part of the risk that affects the market as a whole, already covered in this module's first lesson -- and no further allocation of capital reduces that.
\nThere's no single figure that works for every portfolio. What does exist is a practical criterion: vehicles already covered in Level 1 -- an ETF or an investment fund -- can bring together, on their own, dozens or even hundreds of companies from different sectors and geographic regions, achieving broad spread with a single purchase, compared with building that same diversification by buying individual stocks one at a time. Adding positions that don't provide a genuinely different spread from what's already held -- for example, several companies very similar to each other -- adds complexity to the portfolio without appreciably reducing its risk.
\nThis completes the module: diversifying a portfolio is combining assets that don't all behave the same way, along dimensions like sector and geographic region, up to a point where adding more assets stops providing an appreciable risk reduction. That portfolio composition is one of the elements revisited later, when building a real portfolio from start to finish.
\nAn investor who manually buys ten shares of similar companies within the same sector spends time and effort on limited diversification. Another investor who buys a single ETF with hundreds of companies from different sectors and countries achieves, with a single trade, a much broader spread than the first.
\nThe benefit of reducing risk by adding assets to a portfolio gets smaller and smaller as more are added -- there's no single figure valid for every portfolio, but vehicles like an ETF or an investment fund let you achieve broad spread with a single purchase, without needing to accumulate similar assets that don't provide a genuinely different spread.
\nWhy does the benefit of adding more assets to a portfolio progressively shrink instead of staying constant?
\nWhy can an ETF or an investment fund achieve, with a single purchase, broader spread than buying individual stocks one at a time?
","sortOrder":3,"readingMinutes":7,"difficulty":"Intermedio"},"pathContext":null,"curatedLinks":{"prerequisite":[],"continuation":[],"related":[]},"relatedConcepts":[{"concept":{"id":81,"slug":"diversification","term":"Diversification","shortDefinition":"Combining assets in a portfolio that don't all behave the same way in response to the same events, to reduce risk without proportionally reducing expected return -- it reduces risk, it doesn't eliminate it.","longDefinition":"Diversification is the practice of combining assets in a portfolio that don't all behave the same way in response to the same events -- when some fall, others don't fall to the same degree, or even rise -- which reduces the portfolio's overall risk without proportionally reducing its expected return. It operates within the asset allocation already decided, covered in Module 1: it spreads the capital assigned to each asset class across several specific assets, instead of concentrating it in just one. It can be applied across different dimensions -- for example, geographically and by sector -- all of them forms of the same idea. Diversification reduces risk, but doesn't eliminate it: part of the risk affects the market as a whole, and no allocation of capital within that market eliminates it completely."}}]}