Diversification is the idea of spreading my bets across several things that don’t all fail at the same time, so that no single mistake, accident or piece of bad luck can ruin me. It’s one of the mental models I find most useful, because it applies not only to investing, but also to business, careers, supply chains and life in general.
The essence of Diversification is to accept that I cannot predict the future, and to ask: “If I am wrong about this, or if something unexpected happens, will I still be okay?“
Origin: From Eggs and Baskets to Markowitz
The idea is ancient. The proverb “Don’t put all your eggs in one basket” captures it perfectly: if I drop the basket, I lose every egg. The Bible says much the same in Ecclesiastes 11:2: “Give a portion to seven, and also to eight; for thou knowest not what evil shall be upon the earth.” And in Shakespeare’s The Merchant of Venice (written in the late 1590s), the merchant Antonio explains why he is not worried: “My ventures are not in one bottom trusted, / Nor to one place; nor is my whole estate / Upon the fortune of this present year.“
The modern, mathematical version came from the economist Harry Markowitz. In his 1952 paper “Portfolio Selection” in The Journal of Finance, he showed that what matters is not just the risk and return of each investment, but how they move together. By combining assets that don’t move in lockstep, an investor can reduce risk without necessarily giving up return. This became the foundation of Modern Portfolio Theory, and Markowitz shared the 1990 Nobel Memorial Prize in Economic Sciences with Merton Miller and William Sharpe.
Key Concepts
- Correlation
Diversification only works if things don’t all go wrong together. Correlation measures how closely two things move together. Owning ten things that always rise and fall at the same time is hardly better than owning one. - Systematic vs. Unsystematic Risk
Unsystematic risk is specific to one company, product or person, like a failed product launch or a fraud. It can largely be diversified away. Systematic risk affects everything at once, like a recession, a pandemic or a war, and diversification cannot remove it. - The Risk-return Trade-off
Higher expected returns usually come with higher risk. Diversification is often called the only free lunch in investing, because for a given level of expected return, a well-diversified portfolio can carry less risk. - Diworsification
The investor Peter Lynch coined the term “diworsification” in One Up on Wall Street (1989) to describe companies that expand into businesses they don’t understand. Today it also describes spreading so thin that I add cost and complexity without reducing risk. - A Contrast: the Barbell and Antifragility
In Antifragile (2012), Nassim Nicholas Taleb argues for a barbell strategy: keeping most of my resources extremely safe and putting a small part into bets with large potential upside, while avoiding the risky middle. Instead of only reducing harm, the goal is to be positioned to benefit from surprises.
Some Examples
- Index Funds vs. Single Stocks
A study by Hendrik Bessembinder found that just over 4% of US listed companies accounted for all the net wealth created in the US stock market from 1926 to 2016, while more than half of all individual stocks lost money over their lifetimes. Picking a few winners in advance is hard, which is one reason broad index funds are so popular. See ETFs vs. Index Funds for more (this is education, not investment advice). - A Business with One Customer
A company that gets most of its revenue from a single customer is at that customer’s mercy. If the contract is lost or renegotiated, the business can collapse overnight. - Career Skills and Income Streams
Many Enron employees had much of their retirement savings in Enron stock, so when the company collapsed in 2001, they lost both their jobs and their savings. I try to build a range of skills, relationships and, over time, several sources of income. - Supply Chains
During the global chip shortage of 2020 to 2022, many car makers had to halt production lines because they depended on a few suppliers. Companies with several suppliers and regions were better able to keep going. - Personal Life
I try not to let my whole identity or happiness depend on one thing, like a single job, project or relationship. Having health, family, friends, learning and meaningful work makes life more resilient.
Applying Diversification
When I want to use this mental model, this is the simple process I follow:
- Identify My Exposures
List what I depend on: investments, customers, suppliers, skills, income sources and people. - Find the Single Points of Failure
Ask what one event could hurt me badly, and where too much depends on one thing. - Check the Correlations
Ask whether my different bets would fail for the same reason at the same time. If so, they are not really diversified. - Spread the Risk Sensibly
Add genuinely different sources of value, but only as many as I can understand and manage. - Keep a Margin of Safety
Hold buffers, like savings, spare capacity or extra time, for the risks diversification cannot remove. - Review and Rebalance
Over time, winners grow and concentrations build up, so I review my exposures regularly and adjust.
Pitfalls and Limitations
- Correlations tend to rise in a crisis. In the financial crisis of 2008, many assets that normally move independently fell at the same time, just when diversification was needed most.
- Over-diversification adds cost and complexity. Beyond a certain point, adding more holdings or projects barely reduces risk, but makes everything harder to follow.
- False diversification is common. Owning many funds that hold the same companies, or several businesses that serve the same customer, can look diversified without being so.
- Diversification can mean giving up conviction. Exceptional results often come from focus. As Mark Twain wrote in Pudd’nhead Wilson: “Put all your eggs in the one basket and, WATCH THAT BASKET.” The right balance depends on how much I know, and how much I can afford to lose.
Related Mental Models
- Comparative Advantage
- Economies of Scale
- Game Theory
- The Lindy Effect
- The Hedgehog Concept
- Inversion
- Second-Order Thinking
Diversification reminds me that humility about the future is a strength. By spreading my bets across things that don’t fail together, keeping a margin of safety and still focusing where I truly know something, I can survive the surprises life brings and stay in the game long enough to benefit from the good ones.
To learn more about economics and how key parts of our world work,
check out: Wise: How to Attain a Deep Understanding of the World, History, Our Place in It, and How to Live Well
📚 Sources and References
- Portfolio Selection, The Journal of Finance (1952) by Harry Markowitz
- One Up on Wall Street (1989) by Peter Lynch with John Rothchild
- Antifragile: Things That Gain from Disorder (2012) by Nassim Nicholas Taleb
- Do Stocks Outperform Treasury Bills?, Journal of Financial Economics (2018) by Hendrik Bessembinder
- The Merchant of Venice, Act 1, Scene 1 by William Shakespeare
- Diversification (finance) and Modern portfolio theory, Wikipedia