The concept of diversification makes such common sense that our language even contains everyday expressions that exhort us to diversify ("Don't put all your eggs in one basket"). The idea is to spread your risk across a number of assets or investments. While pointing us in the right direction, this is a rather naive approach to diversification. It would seem to imply that investing $10,000 evenly across 10 different securities makes you more diversified than the same amount of money invested evenly across 5 securities. The catch is that naive diversification ignores the covariance (or correlation) between security returns. The portfolio containing 10 securities could represent stocks from only one industry and have returns that are highly correlated. The 5-stock portfolio might represent various industries whose security returns might show low correlation and, hence, low portfolio return variability.
Meaningful diversification, combining securities in a way that will reduce risk, is illustrated in Figure 5.2. Here the returns over time for security A are cyclical in that they move with the economy in general. Returns for security B, however, are mildly countercyclical. Thus the returns for these two securities are negatively correlated. Equal amounts invested in both securities will reduce the dispersion of return, or, on the portfolio of investments. This is because some of each individual security's variability is offsetting. Benefits of diversification, in the form of risk reduction, occur as long as the securities are not perfectly, positively correlated.
Investing in world financial markets can achieve greater diversification than investing in securities from a single country. As we will discuss in Chapter 24, the economic cycles of different countries are not completely synchronized, and a weak economy in one country maybe offset by a strong economy in another. Moreover, exchange-rate risk and other risks discussed in Chapter 24 add to the diversification effect.