How can diversification reduce investment risk?

Diversification is a fundamental strategy in investment management aimed at reducing risk. By spreading investments across various asset classes, such as stocks, bonds, real estate, and commodities, an investor minimizes the impact of any single asset's poor performance on the overall portfolio. This strategy works because different asset classes often have different responses to market conditions; while one asset might be underperforming due to specific market pressures, another could be thriving under the same conditions.

For instance, when stocks are experiencing volatility, bonds may remain stable or even appreciate, thus providing a cushion against losses. This balance helps to lower the overall risk of the portfolio and can lead to more consistent returns over time.

In contrast, concentrating investments in high-performing assets or increasing investment in a single asset exposes the portfolio to greater risk, as any downturn in that particular investment can cause significant losses. Similarly, completely avoiding all forms of risky assets may lead to missed opportunities for growth, as almost all investments carry some level of risk. Thus, diversification is widely recommended as a prudent strategy for managing investment risk effectively.