What If All Your Eggs Were in the Same Basket?

We are taught this age-old adage as a lesson on spreading out our assets. But how does this concept apply to the stock market and our portfolios?

For example, if Company A had a return of fifteen percent and Company B had a return of ten percent, Company A might seem like the obvious winner. However, when investors began to understand that risk was just as important as reward, diversification became far more important. Company A’s fifteen percent return is less attractive if it comes with much higher risk than Company B’s ten percent return.

So when someone talks about diversifying their portfolio, they mean making sure that the risks they are taking are worth the returns they are getting, and that no single bad outcome can ruin their investments.

However, simply owning more stocks is not the same as diversifying. Imagine you put your money into ten different airline companies. Normally, that feels safe because you are spread across ten businesses rather than one. But when a pandemic grounds flights around the world, all ten of those stocks can fall at the same time. You did not reduce your risk. You just created the illusion of doing so.

This is the concept of correlation. Two investments are correlated when they tend to move in the same direction at the same time. Airlines, hotels, and cruise lines are often highly correlated because a global travel disruption can hurt all of them at once. Owning all three does not protect you the same way owning, say, an airline stock and a pharmaceutical stock might. When travel collapses, demand for medicine does not necessarily collapse with it.

True diversification means owning assets that do not all move together. When one part of your portfolio falls, another part may hold steady or even rise. The overall damage is contained because you avoided having all your risk pointed in the same direction.

This idea is so powerful that economist Harry Markowitz helped formalize it in his 1952 work on portfolio selection, which later became known as Modern Portfolio Theory. His insight showed mathematically that combining assets with low correlation can reduce a portfolio’s overall risk without necessarily reducing its overall return.

Diversification is not about avoiding risk entirely. Every investment carries some risk, and higher returns generally require accepting higher risk. What diversification does is reduce the risks you do not have to take.