Lesson 3.2 · 2 of 5 · Risk and return
Diversification explained simply: how many stocks do you need?
Diversification means spreading your money across several different investments. That way, a problem with one of them matters little overall. An index ETF gives you hundreds of companies in a single purchase, but it does not protect you when the whole market falls.
Terms in this lesson
- Diversification
- You spread your money across several investments, so one mistake does not hurt too much.
- Correlation
- How often two investments rise and fall at the same time.
- ETF
- A fund listed on the stock exchange that buys dozens or hundreds of companies at once.
- Stock market index
- A basket of stocks that shows how a market is doing: S&P 500, DAX, BET.
Opening question
What does it mean to diversify your investments?
Diversification is about how many different investments you hold and how differently they move. Lots of shares in one firm are still a single investment, and big companies can fall a long way too.
It does not matter if you get it wrong: trying first helps you remember.
What diversification means
Definition
What is diversification?
Money spread across investments that don’t all fall at once.
If you hold 10 companies with 10% of your money in each and one goes bust, you lose 10%. If you hold just one, you lose everything. How different they are matters too: ten banks react the same way to a banking crisis. Correlation shows how closely two investments move together. The lower it is, the more diversification helps you.
What you lose if a single company goes to zero.
Compare
Which portfolio is better diversified?
Same number of companies, but B spreads them across sectors and countries. Eight banks in the same country can all fall together in a banking crisis, because they are highly correlated.
How many stocks you need to be diversified
Each extra company lowers risk, but by less each time. The first ones count most: going from 1 to 10 buys you far more safety than going from 40 to 50.
Example
What does the research say?
At least 30 to 40 shares, according to a classic 1987 study.
In 1987 Meir Statman worked out that a well-diversified portfolio needs at least 30 shares for an investor who borrows to invest, and at least 40 for one who does not. Other studies have reached different numbers, depending on the period and how they measure risk. They all agree on one thing: a handful of shares is not enough.
Check yourself
You own 5 shares, all US technology companies. Are you diversified?
How sure are you?
Five companies is not many, and being in the same sector and country means they often rise and fall together. One piece of bad news for tech hits them all.
How an ETF diversifies you
Definition
How does an ETF help?
Hundreds of companies in a single purchase.
An ETF tracking the S&P 500 holds about 500 large US companies, each weighted by its stock market value. The MSCI World index, which many ETFs track, contained 1,249 companies from 23 developed countries on 30 September 2026. You buy a single unit of the fund and own a small slice of all of them.
The line for a single company makes bigger jumps in both directions. The index smooths them out, because the companies’ moves partly cancel each other: when one falls, another rises.
Compare
You want a problem at any one firm to matter as little as possible. Which option do you choose?
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Create a free accountWhat diversification cannot do
Watch out
Which risk remains?
Diversification does not protect you when the whole market falls.
Single-company risk shrinks with diversification. Market risk does not: in a crisis, nearly all shares fall together. Between 9 October 2007 and 9 March 2009 the S&P 500 fell by 56.8%, despite holding 500 companies. Other things help with market risk: time, and keeping part of your money in steadier investments such as bonds.
- Several funds holding the same thingThree S&P 500 ETFs are not more diversified: you own the same companies three times.
- Lots of companies in the same sectorTwenty tech shares often rise and fall together.
- Treating diversification as a guaranteeIt lowers the risk of any single firm, but it guarantees no gain.
Myth or fact?
“If I own an ETF with 500 companies, I can’t lose much.”
This exercise is in the free account, where we also save your progress.
Create a free accountWhat would you do?
You own an S&P 500 ETF. A friend tells you to add a Nasdaq 100 ETF and a US technology ETF “to be more diversified”. What do you do?
This exercise is in the free account, where we also save your progress.
Create a free accountWhat you learned
- Diversification means money spread across investments that don’t all fall at once.
- An index ETF gives you hundreds of companies in a single purchase.
- Diversification lowers single-company risk, not the risk of the whole market falling.
One more time
The questions you got wrong, asked a different way.
Check yourself
Which option cuts single-company risk the most?
Many companies, from different sectors. A firm’s fame or last year’s rise does nothing to lower risk.
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Save your progress with a free accountLessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: M. Statman, “How Many Stocks Make a Diversified Portfolio?”, Journal of Financial and Quantitative Analysis, 1987; the S&P 500’s closing high of 9 October 2007 (1,565.15) and low of 9 March 2009 (676.53); the monthly MSCI World index factsheet (MSCI). The chart shows daily closing prices for Apple shares and the S&P 500.