Diversification is rooted in the statistical principle that combining assets whose returns are not perfectly correlated reduces overall portfolio volatility without necessarily sacrificing expected return. It is often summarised as "don't put all your eggs in one basket."
In practice, a diversified equity portfolio on the CSE would hold positions across multiple sectors — banking, manufacturing, hotels, plantations, consumer goods — so that a downturn in one sector doesn't devastate the entire portfolio. Going further, a truly diversified investor might also hold some fixed-income instruments, cash, and potentially international equities.
True diversification is about economic exposures, not just the number of names in a portfolio. A portfolio of 10 Sri Lankan banks is not well-diversified even if it holds 10 stocks, because all positions are exposed to the same interest rate cycle, credit cycle, and regulatory environment.
Research consistently shows that most of the risk-reduction benefits of diversification are achieved by holding roughly 20-30 uncorrelated stocks. Beyond that, adding more positions has diminishing benefits and increases complexity.