How does diversification help reduce risk in a portfolio?

Diversification assists in reducing risk in a portfolio by spreading investments across various asset classes. When an investor diversifies, they allocate funds to different types of investments, such as stocks, bonds, real estate, or commodities. This strategy minimizes the impact of poor performance in any single investment or asset class on the overall portfolio.

For instance, if one asset class, such as stocks, experiences a downturn, other asset classes, like bonds, might perform well and help offset the losses. As a result, the overall volatility of the portfolio is reduced, promoting more stable returns over time. This approach is based on the principle that different assets respond differently to market conditions. Thus, a well-diversified portfolio is less susceptible to significant fluctuations in value, which is a key aspect of risk management in investing.

The other strategies mentioned, such as investing in a single asset class or concentrating investments within one industry, do not provide the same level of risk protection and can lead to increased volatility and potential losses if those specific investments underperform.