How does diversification help in risk management?

Diversification is a fundamental strategy in risk management that involves spreading investments across a wide range of assets rather than concentrating them in a few. The rationale behind this strategy lies in the principle that different assets perform differently under varying market conditions. By holding a diverse portfolio of assets—such as stocks, bonds, real estate, and commodities—an investor can mitigate the impact of poor performance from any single investment.

When one asset underperforms, others may hold their value or even thrive, leading to a more stable overall performance of the investment portfolio. This reduces the overall risk associated with the investment, since the likelihood of all investments suffering losses simultaneously is lower.

It is important to note that while diversification can effectively lower unsystematic risk (the risk inherent to a specific company or industry), it does not eliminate risk entirely. Market-wide factors or systemic risks can still affect a diversified portfolio. Thus, while diversification meaningfully reduces certain types of risk, it does not guarantee profits, concentrate assets, or remove all forms of risk associated with investing.