Diversification
Diversification is the reduction of risk by holding many investments whose fortunes do not move together, so the losses of one are offset by the gains of others and only the risk common to all — the market's — remains: the same expected return at lower volatility. It fails when holdings move together after all, which is what a crisis is; and it applies to a loan book and a customer base as much as to a portfolio.
- Also known as
- Portfolio diversification, Spreading risk, Not putting all eggs in one basket
- Used at
- portfolio construction everywhere; venture fund sizing (twenty to forty companies because most fail); lending (concentration limits by borrower, sector and geography); payments (merchant concentration); M&A diligence (customer, supplier and sponsor-bank concentration)
- Binding
- for banks and lenders, regulatory large-exposure limits (25% of capital to one counterparty in the EU); for funds, concentration limits in their mandates; otherwise judgement
- Typical evidence
- a portfolio of 20–30 uncorrelated stocks removes most specific risk; beyond that the benefit is small; across asset classes the benefit depends on correlations that rise in a crisis — in 2022 equities and bonds fell together
- Typical fintech concentration risks
- a top customer above 10% of revenue, one sponsor bank, one card scheme, one cloud provider, one country's regulator — each an undiversified exposure a buyer prices
- Parties
- investors, fund managers, risk committees, regulators, and acquirers reading a target's concentration table
How diversification works in practice
An investor holding one fintech stock bears two risks: the market's and the company's — its sponsor bank, its regulator, its founder. Holding thirty stocks across sectors leaves the market's risk and averages away the companies' own; an index fund holds thousands and leaves only the market. The volatility falls, the expected return does not, and the investor is better off for free. Across asset classes the same logic holds while correlations are low — equities and government bonds usually move differently — and breaks when they are not: 2008 and 2022 were years in which most things fell together, and the diversified portfolio was less diversified than its owner thought.
The principle governs businesses as well as portfolios. A venture fund holds twenty-five companies because it cannot know which two will work. A lender caps exposure to any borrower, sector and region because a correlated default — every shopkeeper in one town — is a loss the capital cannot bear. A payments company with one sponsor bank has an undiversified operational risk, and its buyer prices a second sponsor into the plan.
For an acquirer, the target's diversification is diligence: the customer table, the supplier table, the licences, the geography. A company whose largest merchant is 30% of revenue is a company with a beta of 1.0 and a specific risk of 30%, and the price says so.
Example
A buyer values two payments companies with €40m of revenue each. Company A: 3,000 merchants, the largest 2% of revenue, two sponsor banks, three countries. Company B: 400 merchants, the largest five together 45% of revenue, one sponsor bank, one country. Same EBITDA, €8m. The buyer prices A at 10× and B at 7.5×: the €20m difference is the specific risk B carries that A has diversified away — a lost top customer costs A €0.8m and B €5m; a sponsor bank's notice is an inconvenience to A and an existential event for B. B's founders argue that their large merchants are contracted for three years; the buyer's answer is that contracts end, and that diversification is what it would pay for in year four.
Common mistakes
- Counting holdings and calling it diversification when they share one risk — thirty fintech stocks, one interest-rate cycle. - Diversifying across asset classes on correlations from a calm decade. - A venture fund with eight companies, or a lender with a sector it loves. - A fintech that diversifies its revenue and not its dependencies — one sponsor bank behind a thousand merchants. - Over-diversifying into an index at active fees.