What is the goal of portfolio diversification?

The goal of portfolio diversification is to reduce risk by spreading investments across various assets. This strategy is based on the understanding that different assets typically respond differently to market conditions. When an investor diversifies their portfolio, they can mitigate potential losses because not all investments will react negatively at the same time. For instance, while one asset may be performing poorly due to specific market conditions, another might be thriving, which balances the overall performance of the portfolio.

Diversification can include investing in a mix of asset classes, such as stocks, bonds, and real estate, as well as diversifying within asset classes by selecting investments from various sectors and regions. This balanced approach helps to shield the investor from significant losses and volatility, leading to a more stable portfolio performance over time.

In contrast, focusing on a single investment or concentrating funds in one sector can expose the investor to greater risk, as their financial wellbeing is more tightly linked to the success or failure of that one investment or sector. Similarly, pursuing only high-risk investments does not provide the protective benefits that a diversified portfolio offers, making it a less effective strategy for managing overall risk.