Imagine two portfolios on January 1, 2000. Both hold five companies; both companies are excellent. Portfolio A holds five technology names — Cisco, Microsoft, Intel, Oracle, and Sun Microsystems.

Portfolio B holds Cisco, Procter & Gamble, JPMorgan, ExxonMobil, and Pfizer — same number of names, same average quality, but five different industries. Over the next 30 months, the Nasdaq fell 78%. Portfolio A gave back roughly two-thirds of its value; Portfolio B held within 15% of its starting value.

The five-name count was identical; the diversification was completely different. This lesson is about why those two portfolios behaved so differently — and why a portfolio's risk depends much more on what's in it than on how many things are in it. Diversification works mathematically because variance in a combined portfolio depends not just on the variance of each position, but on the correlation between them.