What is diversification and how is it measured?
Diversification means spreading investments across many holdings that do not all move together, so that the poor performance of any one of them has a limited effect on the whole. It is often called the only free lunch in investing: it lowers risk without, on average, lowering the expected return.
It works because part of each investment's risk is specific to it — a failed product, a lost lawsuit, a poor management decision. Such events are largely unrelated to each other, so in a large portfolio they tend to cancel out. What remains is market risk, which affects everything at once and cannot be diversified away.
How it is measured
Number of holdings. The simplest measure, and a poor one: ten positions of which one makes up 70% of the value are hardly diversified.
Effective number of positions. This accounts for the weights. It is the inverse of the sum of the squared weights:
It equals the actual number of holdings when all weights are equal, and it shrinks as the weights become uneven. The sum of squared weights in the denominator is known as the Herfindahl index.
Spread across dimensions. A portfolio can be diversified across companies and still concentrated in one sector, one country or one currency. Sector, regional and currency allocations complete the picture.
A simple illustration
Two portfolios each hold five positions:
| Weights | Effective number | |
|---|---|---|
| Portfolio A | 20% each | 5.0 |
| Portfolio B | 60%, 10%, 10%, 10%, 10% | 2.5 |
Portfolio B behaves like a portfolio of two and a half equally weighted positions.
How much is enough
Research on stock portfolios shows that most of the company-specific risk disappears with 20 to 30 stocks spread across sectors, and that each additional stock adds less. A single broad index ETF holds hundreds or thousands of companies, which gives very high diversification at low cost — although still within the index's own sector and country weights.
Limits
- Correlations rise in crises. When markets fall sharply, many investments fall together, and diversification helps less than it did in calm times.
- Market risk remains. Diversification removes company-specific risk, not the risk of the whole market falling.
- More funds are not always more diversification. Several funds that hold the same companies add complexity, not protection.
A worked example
Worked through on a sample portfolio. The figures below are that portfolio’s, not yours.
How diversified is my portfolio?
Here’s a concise diversification snapshot for your portfolio using today’s figures.
| Metric | Value |
|---|---|
| Total portfolio value [EUR] | 90.983,96 € |
| Number of holdings | 11 |
| Top 1 holding | Apple Inc. (18,41%) |
| Top 5 weight | 65,64% |
| Cash weight | 6,06% |
| Number of asset-class buckets | 5 |
| Largest asset class | Stock (49,09%) |
| ETF allocation | 31,21% |
| Stock allocation | 49,09% |
| Crypto allocation | 8,61% |
| Precious metal allocation | 5,03% |
| Country (top) | United States (62,45%) |
| Region (top) | North America (63,12%) |
| Sector (top) | Technology (39,98%) |
| Market-cap (top) | Mega Cap (53,51%) |
| Country coverage (%) | 99,40% |
| Sector coverage (%) | 99,95% |
| Currency coverage (%) | 100,00% |
What this shows
- Your portfolio value is 90.983,96 € spread across 11 holdings.
- Concentration: your largest single holding is Apple Inc. at 18,41%, and your top five holdings together are 65,64% of the portfolio.
- By asset class: equities (stocks + ETFs) make up the bulk; specifically 49,09% in stocks and 31,21% in ETFs. Crypto and precious metals are smaller allocations at 8,61% and 5,03%.
- Geographic and sector tilt: the portfolio is weighted to United States (62,45%) and Technology is the largest sector at 39,98%.
- Coverage: country and sector coverage are high (99,40% and 99,95%), so the breakdown reflects most of your holdings.
If you want, I can show a table of the top contributors to portfolio volatility or list the top 10 company exposures next.
Related topics
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