Diversification

Diversification is reducing idiosyncratic variance by combining imperfectly correlated risks — it does not cancel a common factor.

Definition

Variance of a sum depends on covariances. Uncorrelated residuals shrink. A hidden common factor (liquidity, vol, the dollar) re-correlates everything in stress. Diversification is a covariance claim.

Why it matters

It is the only free lunch that is not free in a crash. 60/40, multi-strat, and ‘uncorrelated alts’ all learn this the same week.

Case

February 2018 and March 2020: things that were 0.2 correlated went to 0.9. The diversified book was a one-factor book for a month.

How to read it

Name the factor you are not diversified to. Count correlations in a stress window, not only in the last bull.

Memory

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Define Diversification in plain language. Then say why it matters and give one short case. If evidence is thin, say what is missing — do not invent a trading playbook.

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