Diversification is an important strategy used by investors to reduce risk and increase their potential returns. It works by spreading risk across a variety of investments, which helps to reduce any single loss or set of losses.

At its core, diversification involves investing in different assets that do not share the same risk factors. This means that the behaviour and performance of the investments are not correlated or linked to each other. The returns of investments that are not correlated have an excellent chance of offsetting each other when one is down while the other is up.

The main purpose of diversification is to reduce the volatility of a portfolio’s returns over time. When you spread investments over a range of asset classes, such as stocks, bonds, commodities, real estate, and cash, the risk can be managed so that in times of market stress, the diversified portfolio will suffer less volatility than more concentrated portfolios.

One way to diversify a portfolio is to purchase different types of investments. For example, if most of an investor’s portfolio consists of large-cap stocks, the investor can diversify the risk by investing in some small-cap stocks. Similarly, if the majority of an investor’s holdings are domestic investments, they can diversify by investing in foreign securities.

It’s important to remember that diversification is not a guarantee against loss and should not be used as a substitute for due diligence. In addition, investors should be aware that diversifying across different asset classes and markets can result in their portfolio underperforming the broader market, even during upswings.

Ultimately, diversification is a tool that can help investors build a portfolio that is well-positioned to weather market downturns and increase the chances of achieving their long-term investing goals. By incorporating multiple asset classes into their portfolios, investors can mitigate the effects of risk and volatility potentially leading to improved overall returns.