What does diversification in a portfolio help to reduce?

Diversification in a portfolio primarily helps to reduce risks. This practice involves spreading investments across various asset classes, sectors, or geographic locations to minimize the impact of any single investment's poor performance on the overall portfolio. The underlying principle is that different asset classes often react differently to market conditions; when one investment is underperforming, another may perform well, thereby balancing the overall portfolio performance.

By holding a diversified portfolio, an investor can mitigate the risks associated with individual securities, which might be subjected to company-specific risks, sector risks, or market volatility. For example, if an investor only holds stocks in one sector and that sector experiences a downturn, their entire investment could suffer. However, by diversifying into bonds, international stocks, or other assets, the potential for loss is reduced because not all investments will decline simultaneously.

While diversification can influence returns, increase transaction costs, or affect time commitments, its primary benefit lies in risk reduction, making it a fundamental strategy for all investors seeking to protect their capital and achieve more stable returns over time.