Portfolio Diversification for Risk Reduction: What the Research Shows

Last updated: February 2026

Most investors assume that risk and return move in lockstep: accept more volatility, earn higher returns. Classic diversification research tells a different story, one that has practical implications for how advisors construct portfolios and set client expectations.

The Research That Changed Portfolio Construction

In one of the most widely cited studies in portfolio theory, researchers examined how the number of individual stocks in a portfolio affects total risk. The findings were striking in their simplicity. Moving from a single stock to a two-stock portfolio produced a significant reduction in standard deviation (the most common measure of investment volatility). Adding more stocks continued to reduce risk, but at a declining rate. By the time a portfolio held approximately 20 stocks drawn from various industry groups, the bulk of the risk reduction had already occurred. The difference in standard deviation between a 20-stock, 50-stock, or 100-stock portfolio was minimal.

Standard deviation is typically calculated using 36 monthly return observations, though any consistent time period can be used. Mutual fund data providers and advisory services update these figures quarterly, making them readily available for portfolio evaluation.

What makes this finding so useful for advisors is its clarity. Diversification does not require owning hundreds of individual securities to be effective. What matters is holding enough positions across enough industries that the fortunes of any single company cannot dominate the portfolio’s results.

The Surprise: Diversification Reduces Risk Without Sacrificing Return Potential

The most counterintuitive finding from this body of research involves returns. The expected return for a concentrated one- or two-stock portfolio was nearly identical to that of a 20-, 50-, or even 200-stock portfolio. This challenges a belief that many clients (and many advisors) hold instinctively: that greater risk should produce greater reward.

The reason is that diversification primarily eliminates what portfolio theorists call “unsystematic risk,” the company-specific risk tied to individual business outcomes. A pharmaceutical company loses a patent lawsuit. A retailer misreads consumer trends. A technology firm’s product launch fails. These events devastate concentrated portfolios but barely register in diversified ones, because gains from other holdings offset the losses.

Systematic risk (also called market risk) affects all stocks to varying degrees and cannot be diversified away. Recessions, interest rate shifts, and broad market sentiment move the entire market. This is the risk that earns a return over time, and it remains present regardless of how many stocks you hold.

The practical implication: a client with a concentrated two-stock portfolio and a client with a diversified 20-stock portfolio can expect similar average returns over long periods. But their experiences along the way will differ dramatically. The concentrated portfolio has a much wider range of possible outcomes, including both spectacular gains and devastating losses. The diversified portfolio clusters around market returns. Both clients arrive at roughly the same destination; one just takes a far more volatile path to get there.

Why “More Risk, More Reward” Is Not Always True

The assumption that additional risk always brings additional return is one of the most persistent misconceptions in investing. There are well-documented cases where an asset class delivered higher volatility than alternatives without compensating investors with higher returns.

Commodities provide a useful example. Gold mining stocks can exhibit volatility comparable to or exceeding that of aggressive growth equities. Yet over extended periods, gold and precious metals have sometimes trailed far less volatile asset classes. From the early 1970s (when private gold ownership became legal in the U.S.) through the mid-2000s, gold funds underperformed 5-year Treasury notes, a far less volatile investment. More recently, precious metals have experienced stretches of negative annualized returns while U.S. investment-grade corporate bonds delivered steady positive performance with a fraction of the volatility.

This does not mean commodities are bad investments. It means that risk and reward do not exist in a simple linear relationship. The type of risk matters. Unsystematic risk (the kind diversification eliminates) does not earn a premium because investors can avoid it simply by diversifying. Systematic risk (the kind that remains after diversification) is the risk the market compensates. An advisor who understands this distinction can explain to clients why a well-diversified portfolio is not “settling for less” but is instead eliminating risk that was never going to be rewarded in the first place.

Applying the Research: What This Means for Fund Selection

For advisors building portfolios with mutual funds and ETFs, the diversification research reinforces several practical principles.

First, a single broadly diversified equity fund already provides far more diversification than the research suggests is necessary for eliminating unsystematic risk. A total market index fund holding thousands of stocks is well past the point of diminishing returns from a diversification standpoint. The value of holding multiple funds lies not in adding more stocks but in accessing different asset classes, geographies, and risk factors that may not move in tandem.

Second, sector funds and concentrated strategies deserve scrutiny through the lens of this research. A technology sector fund or a portfolio concentrated in a handful of high-conviction picks accepts unsystematic risk that diversification would eliminate for free. That is not inherently wrong, but the client should understand they are accepting volatility that is unlikely to be compensated with higher expected returns.

Third, the research supports building portfolios across asset classes rather than simply adding more equity holdings. A portfolio of 200 U.S. large cap stocks is not substantially more diversified than one holding 30. But adding international equities, fixed-income securities, and real estate (through REITs) introduces fundamentally different return drivers. Research on strategic asset allocation suggests that a well-diversified portfolio can be constructed with as few as four categories: U.S. large cap stocks, U.S. small cap stocks, international developed market stocks, and U.S. investment-grade bonds. Additional asset classes may add modest diversification benefits, but the core architecture does the heavy lifting.

The Client Conversation This Enables

Understanding diversification research equips advisors for one of the most common client conversations: the one where a client asks why their portfolio does not hold “the hot stock” they read about, or why their diversified portfolio is not keeping up with a concentrated index during a narrow market rally.

The answer, grounded in decades of research, is that diversification is not about maximizing returns. It is about achieving market-level returns while eliminating the risk of catastrophic loss from any single holding. The client who owned a diversified portfolio through the dot-com bust, the 2008 financial crisis, or any subsequent market dislocation experienced painful declines. The client who was concentrated in the wrong sector or the wrong handful of stocks experienced something far worse.

Framing diversification as “getting the return you deserve for the risk you are taking” rather than “spreading your bets” changes how clients think about their portfolios. The research shows that concentrated risk does not bring concentrated rewards. It brings a wider distribution of outcomes, and most clients, once they understand this, prefer the narrower path.

The Advisor’s Edge

The data behind portfolio diversification is publicly available. Any investor can look up standard deviation figures, read about unsystematic versus systematic risk, or find the original research. What separates informed advice from raw data is the ability to translate these findings into portfolio construction decisions: selecting funds that provide genuine diversification rather than redundant exposure, evaluating whether a concentrated position is justified by its expected return premium, matching portfolio volatility to a client’s actual risk tolerance and time horizon, and coaching clients through the inevitable periods when diversified portfolios trail concentrated bets. These are the analytical skills that the Certified Fund Specialist (CFS) designation develops across its two-module curriculum. For advisors looking to deepen their understanding of how risk metrics work as a system, the Standard Deviation, Beta, Alpha, and Sharpe Ratio Explained article explores the specific metrics used to evaluate whether a fund’s returns justify its volatility.

Sources and Notes: The diversification research referenced in this article draws from the foundational work of Evans and Archer (1968) and subsequent studies examining portfolio size and risk reduction. Standard deviation calculation conventions follow industry practice as reported by Morningstar, Lipper, and Bloomberg. Asset class return comparisons use publicly available index data. Advisors should verify current figures through their preferred data providers, as performance and volatility metrics change over time. This article is refreshed every 18 months or when major methodology changes occur in the referenced data sources.