How does diversification benefit an investment portfolio?

Diversification benefits an investment portfolio by spreading investments across multiple assets, which helps reduce overall risk. This strategy works on the principle that different assets often respond differently to the same economic events. By holding a variety of investments, such as stocks, bonds, and other assets, the negative performance of one part of the portfolio can be offset by the positive performance of another.

This approach effectively reduces the impact of any single investment's poor performance on the overall portfolio. For instance, if a specific stock in the portfolio declines in value due to company-specific issues, other holdings in different sectors or asset classes may not be affected in the same way, thus mitigating potential losses.

In contrast, focusing solely on high-return stocks may lead to increased risk without the safety net that diversification provides. Similarly, seeking to increase volatility for the possibility of higher returns can expose an investor to greater losses. A strategy that involves investing only in real estate could similarly lead to a lack of diversification, which would not protect the investor if the real estate market were to face downturns. Hence, spreading investments across various asset classes is key to managing risk effectively in an investment portfolio.