1.12. Diversification and ETFs
Lesson objective
Understand how risks can be distributed and learn about a common investment vehicle.
Diversification means spreading money across different investments so that one result has less influence on the entire portfolio. It can involve different companies, industries, sizes, regions, and asset classes.
An ETF is a fund that trades on an exchange and may hold a basket of securities. Some track broad indexes, while others focus on sectors, strategies, or complex products. Buying an ETF does not guarantee adequate diversification if the fund itself is concentrated.
Diversification can reduce the impact of one investment but cannot prevent losses when the overall market declines.
Simple example
A portfolio containing ten similar technology companies may look diversified by position count while remaining heavily exposed to one sector.
Diversification is about independent sources of risk
Portfolio return ≈ Σ (Investment weight × Investment return)
Concentration math
If 50% of a portfolio is in one stock and that stock falls 40%, that position alone subtracts about 20 percentage points from the portfolio. If it were only 5%, the direct effect would be about 2 points.
Think in layers: Company → Industry → Sector → Country/currency → Asset class → Time horizon
An ETF can make diversification easier because one share can represent many holdings, but an ETF can still be concentrated, leveraged, thematic, or expensive. Read what it actually owns.
Essential terms
| Term | Practical meaning | |---|---| | ETF / Exchange-Traded Fund | A fund that trades on an exchange and holds a portfolio of assets. | | Asset allocation | Distribution among categories such as stocks, bonds, and cash. | | Company-specific risk | Risk tied to one company or industry. |
What you should remember
- Diversification does not mean buying many things at random.
- Review what an ETF actually owns.
Practice
Design a hypothetical portfolio and identify concentration by company or sector.