Known as “the only free lunch in finance,” diversification is the practice of reducing one’s investment risk by adding more and more investments (stocks i.e. companies) to one’s portfolio. Why is so much importance given to diversification?

By only owning shares of one stock you essentially have all your eggs in one basket. Let’s say for instance you only hold shares of XYZ Company. By holding this one company your entire portfolio is subject to the performance of XYZ. If XYZ has a good year, your portfolio has a good year, and if XYZ has a bad year, your portfolio has a bad year. Most importantly, if XYZ has an unexpected catastrophe and is forced out of business (Enron, WorldCom, AIG, Lehman Brothers, Fannie Mae, etc.) you lose 100% of your entire portfolio. This is one event with no recovery and is extremely detrimental.

Now let’s say you own two different stocks equally, XYZ and ABC. With the addition of only one company to the portfolio, your specific company risk is significantly reduced. Now if XYZ has an unexpected catastrophe and is forced out of business, all is not lost and 50% of the portfolio’s assets still remain

It is easy to see how owning many stocks can greatly reduce an investor’s portfolio risk and can be done to a point where any one company is such a small portion of the total portfolio that it going out of business has only minimal impact.