According to Wikipedia, “diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.”
Investopedia has a slightly different take, saying that “[d]iversification is a risk management strategy that mixes a wide variety of investments within a portfolio.”
To many, diversification means investing in the market in general. You can do that by investing in a broad market index, such as an ETF that tracks the S&P500 index. There are also the Russel indexes. Basically, if you own the market, you get the market return.
The Contrarian View on Diversification
But diversity does not necessarily have to mean more. The goal of diversification is not to get the market return but to reduce exposure to a particular event.
What you are trying to achieve by being diversified is to make sure not everything you are investing in moves in tandem. By doing so, you embed optionality into your portfolio.
If you accept this reasoning, you will also agree that a portfolio of 5 stocks can be seen as being diversified if those 5 positions are not affected by the same factors.
Think about it this way: Which of the two portfolios is the safer investment strategy?
- Portfolio A: A basket of common stock of the 20 biggest financial institutions in the U.S.
- Portfolio B: A basket of 5 stocks each in a separate industry.