Unit 2 · Level 2 · Diversification
The only free lunch
Imagine owning an ice-cream stand: sunny summers are great, rainy ones are ruin. Now add an umbrella shop. Each business alone is risky, but together your income smooths out: whatever the sky does, something sells. Nobel laureate Harry Markowitz showed this works for portfolios too, and called diversification 'the only free lunch in investing': less risk without giving up comparable expected return.
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What you get asked
What makes diversification reduce risk?
What matters is not the number of holdings but how differently they behave. When one zigs while another zags, the combined ride gets smoother.
Match each setup to what it gives you
Duplicating a bet isn't diversifying it. The umbrella shop helps precisely because its good days are the ice-cream stand's bad days.
Diversification works best when your assets are only ___ correlated.
If everything moves in lockstep, you own one bet wearing many costumes. The weaker the link between holdings, the more the swings cancel out.
What can diversification NOT do for you?
Spreading across stocks kills company-specific risk, but market-wide risk survives: when the whole ocean drops, every boat sits lower. That risk is exactly what stocks pay you for bearing.
Why does diversification earn the nickname 'free lunch'?
Almost everywhere in investing, less risk means less expected reward. Mixing imperfectly correlated assets is the rare exception: a smoother ride to roughly the same destination. 🐜
The rest of this unit
The only free lunch in investing, and the fine print nobody reads.