Money Basics · Lesson 5 of 14
Spread Risk and Pay Attention to Costs
Diversification lowers the chance that one disappointment dominates your finances, and small annual costs add up. Neither removes risk.
In this lesson
- Explain diversification and asset allocation
- Describe what rebalancing does and what it can cost
- Estimate the yearly cost of an expense ratio
Diversification means spreading investments across different holdings so one disappointment is less likely to dominate your finances. Asset allocation is the mix of categories you hold, such as stocks, bonds and cash.
Watch out Names can mislead
Several funds that own the same companies may give you less diversification than their names suggest. Check what each fund actually holds.
What diversification can’t do
Diversification can’t prevent all losses. Many investments can decline together, and their correlation often rises during sell-offs, right when you’d want them to move differently.
Rebalancing means returning your mix toward your intended allocation as prices or circumstances change. Selling to rebalance can create trading costs or taxes, so it isn’t free.
Costs add up
An expense ratio is a fund’s annual operating cost, expressed as a percentage of your money in the fund. Trading fees, borrowing interest and taxes can also reduce what you keep. Read the product documents rather than assuming a low share price makes an investment inexpensive.
Example Consider this example
An annual expense ratio of 0.50% is roughly $50 on an unchanged $10,000 investment over a year. At 0.05%, the comparable amount is about $5. Actual costs vary with the account’s value.
Check your understanding
3 questions. Answer each one, then open “Show answer” to compare.
Question 1 of 3 A fund charges an annual expense ratio of 0.75%. About how much does it cost per year on an unchanged $8,000 investment?
dollarsShow answer
Answer: 60 dollars (anything within ±0.5 dollars counts).
$8,000 × 0.0075 = $60. The fee comes out of the fund’s assets, so you won’t see a bill, but it lowers your return every year.
Show answer
Answer: B. Less diversified than it looks, because the holdings overlap
Diversification depends on what you own, not how many fund names you hold. Overlapping holdings concentrate your risk in the same companies.
Show answer
Answer: False.
Diversification reduces the impact of any one holding, but many investments can fall together, especially in broad sell-offs.
Key takeaways
- Diversification spreads risk; it doesn’t remove it.
- Check fund holdings, because different names can hide the same companies.
- Rebalancing keeps your mix on target but can create costs or taxes.
- Expense ratios, fees and taxes quietly reduce what you keep.
Try it in StratosHedge
Open Market Map and count how many sectors moved in the same direction today. On broad sell-offs, most of the map often moves the same way.
See how sectors move together Needs: Free account
Key terms
- Diversification
- Spreading money across different assets so that one bad outcome can’t sink the whole portfolio.
- Asset allocation
- The mix of categories you hold, such as stocks, bonds and cash.
- Correlation
- How closely two prices move together, from −1 (opposite) to +1 (in step). Correlations often rise in sell-offs, just when diversification matters most.
- Rebalancing
- Moving your mix back toward its intended allocation as prices or circumstances change. Selling to rebalance can create costs or taxes.
- Expense ratio
- A fund’s annual operating cost as a percentage of your money in it. At 0.50%, an unchanged $10,000 costs about $50 a year.
Sources and further reading
Progress is saved in this browser only.
Educational content, not investment advice. Lessons describe how markets and models tend to behave. They don’t tell anyone what to buy, sell or hold. Interactive examples use illustrative sample data, and simulator results are simulated — not actual trading. Options involve risk and are not suitable for all investors.
Risk disclosureCharacteristics and Risks of Standardized Options (OCC) (opens in a new tab)