Does buying more stocks make your money safer?

You buy ten different stocks. Your portfolio looks varied. Then one piece of news arrives, and almost everything moves in the same direction.

Having more names can reduce dependence on a single company. But diversification also requires attention to the risks the holdings share, including concentration within an industry or asset class. [2]

Names versus exposures.

Imagine two fictional companies. One builds holiday resorts; the other runs sightseeing tours. They have different owners, assets and financial statements. Yet both may depend heavily on travelers spending money.

Owning both can spread company-specific risks. It may do less to reduce exposure to a broad fall in travel demand. The company count has increased, but an important common driver remains.

How returns move together.

Correlation describes the relationship between movements in two sets of returns. A value of +1 means they move together perfectly in a linear relationship. A value of 0 means there is no linear correlation; it does not mean the assets are independent or can never fall together.

To isolate its effect, build a hypothetical portfolio with two assets. Each has an annual return standard deviation—our measure of volatility—of 20%. Give each half the portfolio.

When their correlation is +1, the portfolio also has 20% volatility. Set correlation to 0 while keeping everything else fixed, and portfolio volatility becomes about 14.1%. Neither individual asset has become less volatile. The combination has.

Change one assumption.

At a correlation of −1, this exact model produces zero portfolio volatility: equal-sized moves offset one another. That result depends entirely on the assumptions. It does not describe a permanently risk-free combination of real-world stocks.

Outside the model.

Diversification can reduce exposure to a particular holding, but it cannot guarantee that a portfolio avoids losses. Spreading investments across and within asset classes is one way to approach diversification. [1]

Count the risks you share, as well as the names you own.

For the imaginary travel companies, a useful question is how much both rely on the same spending cycle. A second logo on an account statement cannot answer that. The exposures behind the names can.