Why it works
The benefit comes from correlation, not from the count of holdings. Two assets that tend to move independently produce a combined return whose swings are smaller than the average of their separate swings, because a fall in one is often not matched by a fall in the other. Add more assets with low correlation to the rest and portfolio volatility keeps falling, quickly at first and then more slowly, until what remains is the systematic risk shared by the whole market. That residual cannot be spread away. Investors are rewarded, in expected return, for carrying it, and not for company-specific risk they could have spread at almost no cost, which is the central insight of modern portfolio theory.
The regulator's version
The SEC's investor guide puts the case in one sentence: conditions that hurt one asset class may help another, so holding several lets gains in some cushion losses in others. For most individuals the practical route is a broad index fund for each class rather than a hand-picked list. Employees holding a large block of their employer's shares face the opposite of diversification, with wages and savings tied to the same company. The idea sits at the heart of investing and portfolio management, and it explains why leverage on a concentrated position is so dangerous.
- Across companies: many issuers, so any one failure is a small loss.
- Across sectors and regions: so a single industry cycle or national economy does not drive everything.
- Across asset classes: shares, bonds, cash and others, in the proportions set by the asset allocation.
- Across bond issuers and maturities: since one default or one move in rates can hurt a concentrated bond holding.