How does diversification help in risk management?

Diversification is a fundamental strategy in risk management that involves spreading investments across various categories, such as different asset classes, industries, geographic regions, or financial instruments. This approach reduces the overall risk of a portfolio because it mitigates the impact of poor performance in any single investment or category.

When investments are concentrated in a single industry or asset, there is a higher risk that negative performance will significantly affect the entire portfolio. By contrast, if one investment experiences a downturn, others may perform well, balancing the overall performance. This balance is particularly important in volatile markets, where different sectors or assets may respond differently to economic changes or market movements.

The concept of non-correlated assets is central to diversification; when the values of investments are not tightly linked, gains in some can offset losses in others. Therefore, by spreading investments across various categories, an investor can stabilize returns and reduce the likelihood of experiencing severe losses, even in uncertain or fluctuating markets. This strategic allocation helps to manage risk effectively, supporting a more resilient investment approach.