One of the most common investing mistakes is confusing the number of instruments owned with the portfolio’s level of diversification. Having five ETFs, ten funds or twenty stocks can give the impression that risk is very well spread, but that is not necessarily true. If those instruments invest in the same markets, the same sectors or even the same companies, the portfolio may remain heavily concentrated despite its many holdings. CONSOB describes precisely this phenomenon as a form of naive diversification: believing you are diversified merely because you own many instruments, without analysing how different they really are from one another.

Diversification therefore means spreading wealth across different sources of risk so that a single event does not have an excessive impact on the entire portfolio. The number of instruments can help achieve this objective, but it is only a means. What really matters is what those instruments contain and how their different components respond to the same economic events.

Why diversify?

Imagine investing all your wealth in the shares of a single company. If that business grows strongly, the result can be excellent. But if it loses competitiveness, suffers a financial crisis, becomes involved in a scandal or fails, the entire portfolio is affected.

Spreading the same capital across many companies reduces this company-specific risk. The failure of one company would have a much smaller impact on overall wealth.

The Bank of Italy describes diversification using the traditional expression “do not put all your eggs in one basket”, explaining that it can involve instruments differing in type, maturity and geographical area. If returns on the various components do not always move in the same direction, part of the portfolio can at least partially offset another part’s negative performance.

This does not mean a diversified portfolio cannot lose money. During a financial crisis, many assets can fall simultaneously. Diversification mainly helps prevent results from depending excessively on a single security, sector, country, issuer or risk factor.

Ten stocks in the same sector do not necessarily mean diversification

Suppose we build a portfolio containing ten US technology companies. Formally, we are no longer investing in a single business, so we have reduced the risk of problems specific to that company. But the ten companies may be sensitive to the same factors: interest-rate movements, high technology-sector valuations, demand for semiconductors, digital regulation or the performance of the American economy.

If the entire technology sector undergoes a sharp correction, all the holdings may fall simultaneously.

A portfolio of ten technology companies may therefore be less diversified than a portfolio comprising a few genuinely different assets.

The same reasoning applies to bonds. The Bank of Italy observes that concentrating investments in a single issuer is risky, but that buying many bonds with very similar maturities and characteristics can also leave a portfolio heavily exposed to the same interest-rate risk.

Diversification is therefore multidimensional.

Five ETFs can contain almost the same companies

The issue becomes particularly interesting with ETFs. Imagine an investor simultaneously owning:

At first glance, this looks like a portfolio of five different investments. But examining the holdings might reveal that many large US technology companies appear in all five funds.

A particular company might represent 4% of the global ETF, 7% of the S&P 500, 9% of the Nasdaq, 15% of the technology ETF and a substantial share of the artificial-intelligence fund as well.

Buying all these ETFs does not necessarily add diversification. We might simply be increasing exposure to the same stocks several times over.

This phenomenon is often called overlap, meaning duplication among different funds’ holdings.

The question should therefore not be “how many ETFs do I own?”, but:

“Which companies, countries, sectors and risk factors do I own overall after combining all my ETFs?”

One ETF can be more diversified than five

It may seem paradoxical, but a single fund tracking a broad global index could hold thousands of securities across numerous countries and sectors. Five sector ETFs, by contrast, might contain far fewer companies overall and, above all, be exposed to much more similar risks.

The Bank of Italy identifies mutual funds and ETFs as instruments through which even small savers can achieve diversification that would be difficult and expensive to obtain by buying dozens or hundreds of securities directly.

This does not mean one ETF is always sufficient. It depends on the index tracked and the portfolio’s objective. A banking-sector ETF remains highly concentrated even if it contains fifty banks. A single-country ETF remains mainly exposed to that economy. But it demonstrates that the number of financial products and the degree of diversification are two different concepts.

Geographical diversification

One of the first dimensions to examine is geography. Investing everything in Italian companies means tying much of the result to the performance of the Italian economy, national regulation and the European market.

Adding US, European, Asian or other market assets can reduce dependence on a single economic area. But here too, actual exposures need to be examined.

A company may be listed in the United States and earn a significant share of its revenue in Europe and Asia. Similarly, a European multinational may depend heavily on American demand.

The geography of a listing therefore does not necessarily match the company’s economic geography.

For this reason, perfect geographical diversification is more complex than simple labels such as “USA”, “Europe” or “Asia” suggest. Nevertheless, avoiding dependence of one’s entire wealth on a single country remains a fundamental principle of risk management. Guidelines applied to financial advice also expressly include geographical exposure among the dimensions to assess when monitoring portfolio concentration.

Sector diversification

Another dimension concerns economic sectors. Technology, banking, energy, industry, pharmaceuticals and consumer goods can respond differently to changes in the economy.

For example, an increase in oil prices can benefit some energy companies while simultaneously raising costs for businesses heavily dependent on fuel. The Bank of Italy uses a similar example to show how different assets can respond in opposite ways to the same economic event.

Spreading capital across different sectors therefore reduces the risk of a sector-specific problem damaging the entire portfolio.

Here too, however, an overly mechanical interpretation should be avoided. Different sectors can still become highly correlated during crises. Diversification reduces risk; it does not provide a guarantee against losses.

Diversifying across asset classes

Diversification can also involve different categories of assets, known as asset classes.

Shares, bonds, cash and property have different characteristics in terms of risk, expected return, volatility and accessibility. The Bank of Italy explicitly includes these categories in its definition of diversification.

A portfolio consisting 100% of shares in thousands of companies may be very well diversified within its equity component, but it remains fully exposed to equity-market risk.

Introducing bonds, for example, adds a different source of return and risk.

This does not mean bonds and shares necessarily always move in opposite directions. There may be periods when both fall simultaneously. The logic is simply to avoid having all your wealth depend on the same asset class.

Currency diversification

Currencies also represent a source of risk.

A European investor holding assets denominated in, or economically exposed to, the dollar may earn a different return from an American investor because the euro/dollar exchange rate can change in the meantime.

Holding assets in different currencies can contribute to diversification, but can also introduce additional volatility.

European guidelines on portfolio assessment specifically consider currency exposure, alongside geographical exposure and asset classes, as one of the relevant dimensions of diversification.

This once again shows why analysing only the number of securities is insufficient.

Diversifying across issuers too

Concentration can be particularly dangerous in bonds.

Suppose someone owns five different bonds issued by the same bank. They might have five different ISIN codes, five maturities and five coupons, but their credit risk would still depend largely on that same bank’s ability to repay its debts.

If the issuer ran into serious difficulties, all the bonds could be affected simultaneously.

CONSOB and ESMA specifically emphasise the importance of monitoring exposure to individual issuers or companies belonging to the same group, because excessive concentration can produce substantial losses in the event of insolvency.

Five bonds therefore do not necessarily amount to five independent risks.

The fundamental concept is correlation

Behind the entire theory of diversification lies a particularly important concept: correlation.

Put simply, correlation measures how much two investments tend to move together. If two assets almost always rise and fall at the same time and in the same direction, owning both adds little diversification. If instead they respond differently to the same events, combining them can reduce the portfolio’s overall variability.

You do not need to know complex statistical formulas to understand the intuition.

Imagine two companies that both produce semiconductors. Their results may depend on the same economic factors. Buying both reduces company-specific risk, but not sector risk.

If, instead, some capital is invested in semiconductors and some in government bonds, the sources of risk become more distinct.

Effective diversification therefore seeks to combine risks that do not overlap perfectly.

The illusion of equal percentages

There is also another form of naive diversification: dividing capital equally without asking what risk each investment represents.

Suppose we own four instruments, each with a 25% weight. We might conclude that the portfolio is perfectly balanced.

But if three instruments are very similar equity ETFs and the fourth is a short-term bond, the equity component could actually account for 75% of the wealth.

More importantly, the instruments may have very different volatilities. An investment that fluctuates by 30% a year contributes much more to overall risk than one that fluctuates by 3%, even if both have the same monetary weight.

Diversification therefore concerns not only the amount of capital allocated to each holding, but also how much risk that holding introduces into the portfolio.

A home can also create wealth concentration

The principle does not apply only to financial markets.

Imagine a household with net wealth of 300,000 euros, consisting of:

The household owns various assets, but around 90% of its net wealth is concentrated in a single property, in a single city and in a single property market.

This does not mean owning a home is wrong. It does mean, however, that examining overall wealth rather than just the financial portfolio reveals substantial property concentration.

The Bank of Italy also includes property and cash among the different assets that can be considered when diversifying overall wealth.

It is therefore possible to have a highly diversified financial portfolio and heavily concentrated overall wealth.

The risk of overdiversification

After understanding the importance of diversification, one might make the opposite mistake: buying ever more instruments on the assumption that each new holding automatically improves the portfolio.

Beyond a certain point, however, adding very similar instruments may not meaningfully reduce risk and may instead increase complexity, fees and monitoring difficulties.

A portfolio with fifteen ETFs may require constant rebalancing and make it difficult to understand actual exposure to different markets. If many funds overlap, the additional complexity may produce no real benefit.

Diversification should therefore serve a specific purpose. Each new instrument should add something the portfolio does not already have: another asset class, geographical area, maturity, risk profile or source of return.

If it does not meaningfully change exposures, it may simply be a duplicate.

How to check whether a portfolio is truly diversified

An initial check can be made by examining the overall composition of your wealth. Extremely sophisticated mathematical models are not necessary. A few questions are enough.

How much of your wealth is in equities? How much in bonds? How much in cash? In which countries are the assets concentrated? What are the main sectors? What weight do the top ten companies carry? How many instruments depend on the same issuer? Which currencies have the greatest impact on the result?

For ETF investors, it is particularly useful to examine the top holdings and compare them across funds. If the same names appear repeatedly, there is overlap.

You can also calculate a company’s effective weight in the portfolio. If 50% of the capital is invested in an ETF in which one company has a 10% weight, and another 30% is invested in a second ETF where that company has a 15% weight, overall exposure to that company is:

50% × 10% + 30% × 15% = 9.5% of the portfolio

Even without directly owning a single share, almost one tenth of your wealth may therefore depend on that company.

More instruments can also increase costs

Each product may involve management fees, trading costs, spreads and tax consequences. Increasing the number of instruments can therefore make the portfolio more expensive, especially if frequent purchases and sales are made to maintain particular weights.

The Bank of Italy notes that funds and ETFs can make diversification simpler for small investors precisely because buying very many securities directly would be complex and expensive.

But using ten funds to obtain exposures that could be replicated with one or two instruments does not necessarily improve the result.

Here too, simplicity can be an advantage.

Diversification and returns

Diversifying also means accepting that the entire portfolio is unlikely to be the best-performing investment of the moment at the same time.

If one sector gains 40% while another remains unchanged, someone concentrated entirely in the first sector will earn a higher return than a diversified investor.

In hindsight, it will therefore always be possible to identify an investment that would have delivered more.

But diversification is not intended to maximise returns in a scenario we already know. It is intended to manage uncertainty before knowing which sector, country or company will perform best.

The Bank of Italy summarises the principle by stating that, for the same expected return, greater diversification allows risk to be reduced.

It is therefore a strategy for managing uncertainty, not a method for obtaining the highest possible return in every period.

Diversification does not eliminate market risk

Even a highly diversified portfolio can lose value.

If the global economy enters recession, a financial crisis occurs or interest rates rise rapidly, many assets can be affected simultaneously.

Risk affecting the entire system cannot be eliminated simply by adding more securities. CONSOB expressly emphasises that diversification serves to contain risk, not make it disappear.

This is particularly important because the word “diversified” can mistakenly be interpreted as synonymous with “safe”.

It is not.

A global equity portfolio can be extremely diversified and still experience large fluctuations during a crisis.

Diversifying means knowing which risks you are exposed to

The real question should therefore not be how many financial instruments we own. We should ask which factors could make them lose value simultaneously.

If a change in interest rates, a technology crisis or a US recession would affect most holdings in the same way, diversification may be lower than it appears.

CONSOB, the Bank of Italy and ESMA treat the principle multidimensionally: instruments, issuers, sectors, geographical areas, currencies, asset classes and other risk factors must be considered together.

That is the difference between owning many products and actually building a portfolio.

Conclusion

Diversification does not mean filling a portfolio with financial instruments.

Five ETFs may contain almost the same companies. Ten stocks may belong to the same sector. Five bonds may depend on the same issuer. And wealth comprising different instruments may still be almost entirely exposed to a single country or asset class.

Effective diversification instead comes from combining different sources of risk.

You need to examine the underlying composition, not just the number of lines in the portfolio.

That is why the most useful question is not: “How many investments do I own?” but: “If one of my portfolio’s main risks materialised, how many of my assets would be affected simultaneously?”

If the answer is “almost all of them”, the portfolio may be much less diversified than it seems.

In finance, having many eggs is no help if ultimately they are all in the same basket.