Can diversification eliminate risk or just reduce (i.e., mitigate) it?

Question

In portfolio theory, diversification is often presented as a way to manage risk. However, does diversification completely eliminate risk or just reduce (mitigate) it? And how does this distinction apply to systematic and unsystematic risk?

• Unsystematic Risk: It’s said that diversification eliminates (or just mitigates?) unsystematic risk. But is this absolute? If an investor still has exposure to a company or industry (e.g., through concentrated holdings), is the risk merely reduced rather than eliminated? Wouldn’t full elimination require zero exposure?

• Systematic Risk: Diversification across companies and sectors doesn’t help with systematic risk, but does diversifying across asset classes (stocks, bonds, real estate, commodities) meaningfully mitigate it? If assets become highly correlated during market crises (e.g., 2008), does diversification provide real protection?

Answer 1

"Risk" is a word that has many different meanings, especially in Finance. It's important to understand what type of risk (or more specifically, risk of what) you're trying to understand.

In a diversification context, there are two types of risk that are involved. One common use of "risk" is "variance of returns". In a portfolio, the variance of returns depends not only on the variance of individual securities, but also how that are correlated. If two securities are perfectly correlated, then their total variance will just be the sum of the individual variances (I'm simplifying the math a bit here). If two securities are uncorrelated, or less than perfectly correlated, their total variance will be less than the sum. If they are perfectly negatively correlated (as one moves up, the other moves down an equal amount), then the total variance will be zero.

So diversification, or choosing investments that are at worst loosely correlated, will reduce the variance of returns. As some stocks go up, others will go down, reducing the variance.

It's also used to distinguish between idiosyncratic (or "unsystematic") risk and systemic risk as you mention. The market itself has some inherent risk that you can't diversify away, but you can reduce variance by investing in multiple loosely correlated markets, which reduces variance just like diversifying stocks.

To answer your question, it can eliminate some types of risk and can reduce overall risk, but it cannot eliminate risk altogether.

But there are other types of risk that you and others mention - risk can also means "probability of something bad happening" like a market crash, or an asteroid. That type of risk can't be mitigated by diversification, but rather through other means like stop losses.

Answer 2

You're overthinking this. Let's take an extreme example to show why: a killer asteroid, like the ones that wiped out the dinosaurs, is a unlikely but non-zero risk. No diversification strategy can eliminate or mitigate that risk.

Because diversification is still useful, many investors do use that strategy, also across asset classes. That does mean that during market crises, available investment capital shrinks, demand drops across all asset classes, and prices will go down. In the end, all asset classes are connected via money.

Answer 3

You can never remove all risk. In fact you can't even remove most risks. What you can do, somewhat, is choose which risks you want to be more or less exposed to.

To the extent that risk-free investments can exist, their price will very quickly be bid up to the point where they are no longer risk-free.

Answer 4

In theory, you could do the following (ignoring inflation):

• You have $100
• You invest $75 in some product which:
  • guarantees your capital
  • guarantees a return of 3% per year, compounding
• You invest the remaining $25 in whatever super-high-risk-but-potential-high-reward product
• You wait 10 years.

At the end of that, your $75 will have become a tiny bit over $100, and the $25 will have become whatever they will have (0, a lot, or anything in between).

• Worst case: the $25 are gone, but you still have $100.
• Best case: the $25 are now worth thousands. Of course it's (4 times) less than if you had invested the full $100 into that, but then you would have been at risk of losing everything.

This is an extreme case of diversification, with just two classes of investments: very safe and very risky (but potentially very lucrative). Of course you can then further diversify the higher-risk share.

You just need to be sure that the first product does indeed deliver on the two requirements. They're usually some form of government treasury bonds/bills/notes or similar products, but depending on the market it may be more or less difficult to find products with the right yield.

Also note you may need to adjust for inflation.

Once you have the right figures you can adjust the proportions. And if after all you are willing to take "some risk" you can adjust the proportions to reflect that.

Answer 5

Unsystematic Risk: It’s said that diversification eliminates (or just mitigates?) unsystematic risk. But is this absolute? If an investor still has exposure to a company or industry (e.g., through concentrated holdings), is the risk merely reduced rather than eliminated? Wouldn’t full elimination require zero exposure?

Perfect diversification eliminates unsystematic risk (assuming Efficient Market Hypothesis; and if you aren't assuming EMH, then all bets are off as to what is optimal allocation). That follows from the definitions of "perfect diversification" and "unsystematic risk". Perfect diversification is diversification the minimizes risk for a particular level of return, systematic risk is what's left over after perfect diversification, and unsystematic risk is what's left over after systematic risk is accounted for.

Perfect diversification consists of allocating your portfolio across all positions weighted by market capitalization. If your holdings are concentrated in a particular firm or sector beyond that, then you don't have perfect diversification, and unsystematic risk is not eliminated.

Elimination of unsystematic risk doesn't require no exposure, it requires equal exposure (all in, cap-weighted). Equal exposure still has systematic risk, but not unsystematic.

Diversification across companies and sectors doesn’t help with systematic risk, but does diversifying across asset classes (stocks, bonds, real estate, commodities) meaningfully mitigate it?

Systematic risk is often given in terms of just the stock market. So diversifying over asset classes, and different markets (i.e. foreign markets) can reduce risk below the systematic risk of the stock market. So it would arguably be more accurate if people in finance used "systematic risk" to refer to all investments available, but that is not common practice, and has there are practical barriers to working with that.

If assets become highly correlated during market crises (e.g., 2008), does diversification provide real protection?

Higher correlation tends to reduce the benefits of diversification, but as long as the correlation isn't perfect (which it never is), there is still some benefit.

Also, something to consider is that correlation is the square root of the coefficient of determination. The coefficient of determination is a measure of what percentage of the variance is attributable to common movement. That is, if most of the variance of a stock consists of the stock moving the same way as the rest of the market, then the correlation will be high. In other words, a stock's variance can be decomposed into two components. One set of terminology for these components are "explained" and "unexplained", where the "explained" component is variance that follows the market, while "unexplained" variance is variance particular to the stock. The coefficient of determination is then the ratio of the explained variance to the total variance.

So there are two ways that correlation can go up. If the amount of unexplained variance goes down, then the explained variance becomes a larger percentage of the total. Or, if the explained variance increases, that will also result in it being a larger percentage. Thus, a higher correlation doesn't necessarily mean lower particular variances. The higher correlation of 2008 was caused largely by the explained variance going up, rather than the unexplained variance going down (in fact, my guess is that the particular variance also went up, just not as much).

So while the decrease in risk achieved by diversification was lower as a percentage of total risk in 2008, that doesn't mean that the decrease in risk was lower, in an absolute sense.

Answer 6

Diversification can’t eliminate risk entirely, but it can definitely reduce it. By spreading your investments across different assets, industries, or markets, you minimize the impact of any one underperforming. However, it doesn’t protect against systemic risks—those that affect the entire market (like economic downturns). So, think of it as a tool to mitigate risk, not erase it.