What is diversification?

Diversification means spreading investments, customers or suppliers across several sources so that no single failure dominates the outcome. It works when the parts do not rise and fall together. The goal is to reduce the swings of the whole without necessarily giving up the average result.

How it works

The effect comes from correlation, which says how closely two things move together. If two assets always move the same way, combining them reduces nothing. If they move independently, bad periods for one tend to coincide with ordinary or good periods for the other, so the combined result is steadier. For two assets with equal weights, the portfolio's swing is lower than the average of the two swings whenever the correlation is below one.

There are limits. Diversification removes risk that is specific to one asset, but not risk shared by everything, such as a market-wide crash, when correlations tend to jump toward one. Adding more and more holdings also gives smaller and smaller benefits.

Example

Say you hold 1,000 in one business whose yearly result is either +30% or −20%, each equally likely. The average is +5% but a loss is half the time. Now split it 500 and 500 across two independent businesses with the same odds. The chance both lose is one in four, and the chance both gain is one in four, and the other half of the time you land near +5%. The average is the same +5%, but the chance of a loss of 20% on the whole falls from 50% to 25%. This is an illustration.

How to model it in Machinations

Draw several Pools for holdings, each fed by its own Register that draws a random return per step. Use a Lever to set how much of the starting capital goes to each, and a Register that sums the Pools into the total. Play many times at once and chart the total: moving from one holding to four narrows the spread of outcomes. Make two Registers draw from the same shared value to see what happens when they are correlated.