How does diversification reduce investment risk?

Diversification reduces investment risk primarily by spreading investments across various asset classes. This strategy involves allocating capital among different types of investments—such as stocks, bonds, real estate, and commodities—instead of concentrating all resources in a single asset or asset class.

The logic behind diversification is that different asset classes often react differently to the same economic events. For example, when stock prices fall, bond prices may remain stable or even increase as investors flee to safety. By having a mix of asset classes, the overall portfolio can balance out losses in one area with gains in another, which leads to reduced volatility and risk.

Additionally, diversification allows investors to minimize the impact of a poor-performing investment on their overall portfolio. Even if one investment underperforms, its drag on the portfolio can be offset by other investments that perform well. This strategic approach can lead to more consistent returns over time while helping to manage the inherent risks involved with investing.