I always heard that “diversification” was the way to reduce investment...

There are two types of investment risk. Systematic risks affect securities system-wide, whereas unsystematic risks affect only certain market sectors or companies at any given time. Diversification spreads unsystematic risks among many issuers and industry groups. It has no effect on the first type, systematic risk.

For example, market risk is a type of systematic risk that affects securities across the board. Market risk is the risk that an investment will lose value due to an overall market decline. No one can predict the next war, pandemic, or banking crisis, but when events like that take place, they can have a devastating effect on the overall market for stocks and bonds. 

Whether they panic because of war, weather, or whatever, when investors panic, securities prices drop. So, even if an investor holds shares in several solid companies, when securities holders all try to sell at the same time, the market prices of securities across the board drop. 

Unfortunately, diversification does not help in this case. If the overall market is going down, it does not matter how many different stocks or bonds we own. They are all going down. That is why we would have to bet against the overall market to protect against market risk. The S&P 500 index is generally used to represent the overall stock market. Therefore, investors use options, futures, and ETFs based on such indexes to bet the overall market will drop. 

Beta measures market risk. A beta of 1.3 indicates the stock is more volatile than the S&P 500—1.3 times as much, and the S&P 500 is already volatile. A beta of .8 indicates the stock is less volatile than the S&P 500—only 80% as volatile. The higher the beta of a stock, the greater the market risk faced by an investor in that security. Investors following modern portfolio theory and its related tenets believe this is the only type of risk an investor should expect to be compensated for taking. 

Why? Because unsystematic risks can be diversified and thereby reduced. This type of systematic risk is “non-diversifiable,” and so the more of it one faces, the higher the potential return.