Diversification Explained: Why One Stock Is Riskier Than Many

Diversification means spreading your money across many investments so that a disaster at any one of them does only limited damage. It works because individual companies have problems of their own (a failed product, a fraud, a lost lawsuit) that are unrelated to each other, and holding many of them lets those separate risks partly cancel out.

In short: diversification reduces the risk that is specific to individual companies, which is large, without necessarily reducing expected return. It cannot remove the risk that the whole market falls together. The amount of risk it removes depends on how closely your holdings move with one another, a property called correlation.

Two kinds of risk

Every stock’s ups and downs can be split, roughly, into two parts:

Company-specific risk (also called idiosyncratic or unsystematic risk). A drug fails its trial, a CEO resigns, a factory burns down, an accounting problem comes to light. These events hit one company, or a few.
Market risk (systematic risk). Recessions, interest-rate changes, financial crises and pandemics push most stocks in the same direction at once.

Diversification attacks the first kind. If you own one stock and it collapses, you lose a lot. If you own 200 and one collapses, you lose about half a percent. Market risk is different: when nearly everything falls together, owning more of “everything” does not help much. The full list of risks is in stock market risks explained honestly.

Why single stocks are riskier than they look

It is easy to assume that a typical stock does roughly what the market does. The long-run record says otherwise.

In a widely cited study, “Do Stocks Outperform Treasury Bills?” (Journal of Financial Economics, 2018), finance professor Hendrik Bessembinder looked at every US common stock in the CRSP database from 1926 to 2016. He found that four out of every seven had lifetime buy-and-hold returns lower than one-month US Treasury bills. And the net wealth created by the entire US stock market over that period, above what Treasury bills would have earned, came from just 4.3% of the companies (1,092 firms). The rest, taken together, roughly matched Treasury bills.

The market as a whole did very well. The typical individual stock did not. A diversified portfolio is how you make sure you own the small number of companies that end up driving the market’s return, because nobody can reliably identify them in advance. See what is a stock for what you actually own when you hold a share.

Correlation: the engine of diversification

Correlation measures how closely two investments move together, on a scale from -1 to +1:

+1: they move in perfect lockstep. Holding both gives no diversification.
0: their movements are unrelated.
-1: one goes up exactly when the other goes down.

Most pairs of stocks have positive correlations, typically well below +1. Companies in the same industry tend to be more correlated with each other than companies in different industries.

A two-stock worked example

Volatility is usually measured as the standard deviation of returns. Suppose two stocks each have a volatility of 30% a year and you split your money 50/50. The portfolio’s volatility depends on their correlation:

Correlation	Portfolio volatility
+1.0	30.0%
+0.3	24.2%
0.0	21.2%

The formula for two equal weights is: volatility = √(0.25σ² + 0.25σ² + 2 × 0.25 × ρ × σ²), where σ is each stock’s volatility and ρ is the correlation. With σ = 30% and ρ = 0.3, that is √(0.0225 + 0.0225 + 0.0135) = √0.0585 ≈ 24.2%.

Each stock on its own swings 30% a year. Together, with a modest 0.3 correlation, the pair swings about 24%. The expected return of the pair is just the average of the two, but the risk is lower than either one. That is the core of why diversification is called the closest thing to a free lunch in investing: risk falls without giving up average expected return.

How many stocks is enough?

Extend the same idea to many stocks. Assume every stock has 30% volatility, every pair has a 0.3 correlation, and you hold equal amounts of each. The portfolio’s volatility is σ × √(ρ + (1 - ρ) ÷ N), where N is the number of stocks:

Number of stocks	Portfolio volatility
1	30.0%
2	24.2%
5	19.9%
10	18.3%
20	17.4%
30	17.1%
100	16.6%
Unlimited	16.4%

Two lessons jump out:

Most of the benefit comes early. Going from 1 to 20 stocks cuts volatility from 30% to about 17%. Going from 20 to 100 cuts it only another 0.7 percentage points.
There is a floor. Even with unlimited stocks, volatility stays at about 16.4% in this model. That floor is the market risk diversification cannot remove.

Academic estimates of “enough” vary with the assumptions. Meir Statman’s 1987 paper “How Many Stocks Make a Diversified Portfolio?” (Journal of Financial and Quantitative Analysis) argued for at least 30 to 40 stocks. Later research found that individual stocks have become more volatile relative to the market, which pushes the number higher. And volatility is not the only concern: the Bessembinder result suggests that a 20-stock portfolio has a real chance of missing the few big winners entirely. A broad index fund sidesteps the question by holding hundreds or thousands of companies.

Diversifying across more than stocks

Diversification can happen at several levels:

Across companies within a market.
Across sectors, so one industry’s bad decade does not sink you.
Across countries, because national economies and currencies do not move in lockstep.
Across asset classes, such as stocks and bonds, which behave differently in many environments (see stocks vs bonds).
Across time, by investing and withdrawing gradually rather than all at once.

Home-country bias

Investors everywhere tend to own mostly stocks from their own country. That is called home bias, and it can be a large, unintended bet.

According to MSCI’s ACWI Index factsheet (2026), Canada makes up about 3% of the global stock market as MSCI measures it, and the United States about 64%. A Canadian who holds only Canadian stocks is betting most of their portfolio on 3% of the world. The S&P/TSX Composite is also unusually concentrated by sector, with large weights in banks, energy, and materials, so an all-Canadian portfolio is a sector bet as well as a country bet.

US investors face a version of the same issue in reverse. The US is a large share of global markets, so a US-only portfolio is less extreme, but it still leaves out roughly a third of the world’s listed companies and is exposed to a single economy, currency, and policy environment.

There can be reasons to tilt toward home: no currency risk on everyday spending, and in Canada a dividend tax credit on eligible Canadian dividends. Those are reasons for a tilt, not necessarily for owning only domestic stocks.

Currency risk for Canadians

When a Canadian owns US stocks, returns depend on both the stock and the exchange rate. If a US stock rises 10% in US dollars but the US dollar falls 5% against the Canadian dollar, the gain in Canadian dollars is about 1.10 × 0.95 - 1 = 4.5%. Currency moves can add to or subtract from returns in any given year, which is itself a form of diversification as well as a risk.

What can go wrong

Correlations rise in a crisis. In sharp selloffs such as 2008 and March 2020, most stocks fell together. Diversification across stocks offered less protection exactly when people wanted it most. See stock market crashes in history.
Overlap is not diversification. Owning five funds that all hold the same large companies can feel diversified while being mostly one bet.
Employer stock concentration. Holding a large share of your savings in the company that also pays your salary doubles up your risk: if the company struggles, your job and your savings can suffer together.
Diversification can mean owning things you would rather not. A broad index includes companies that will decline and fail. That is the price of making sure you also hold the ones that succeed.
It reduces the chance of a huge win. If you concentrate and pick the right stock, you do better than a diversified portfolio. The problem is that the odds of picking right are low, as the data above shows.

The short version

Diversification cuts company-specific risk by holding many investments whose fortunes are not tightly linked. The benefit depends on correlation, comes mostly from the first few dozen holdings, and stops at the floor of market risk. Because most individual stocks have historically trailed even Treasury bills while a small minority drove the market’s gains, broad diversification is how you make sure you hold the winners. Look beyond your own country, too.