What does diversification in a portfolio help to do?

Diversification in a portfolio refers to the practice of spreading investments across various asset classes, sectors, or geographic regions. This strategy helps to mitigate risk by ensuring that the performance of the overall portfolio does not heavily depend on the success or failure of any single investment. When one asset class is performing poorly, the other asset classes may perform well, which can help to balance out the overall return of the portfolio.

By incorporating a diverse range of investments, an investor can reduce the potential volatility of their portfolio and protect against significant losses. This concept is based on the principle that different investments react differently to economic changes, market conditions, and other external factors, thereby providing a buffer that can stabilize returns over time.

While diversification is effective in reducing risk, it does not guarantee against losses or eliminate all investment risks. It also does not focus solely on maximizing returns without considering risk. Such a strategy would contradict the fundamental purpose of diversification, which seeks to maintain a balance between risk and return for healthier investment outcomes.