What effect does diversification have on investment risk?

Diversification is a fundamental strategy in investment management aimed at reducing risk. By spreading investments across various asset classes, industries, or geographic regions, diversification mitigates the potential negative impact of poor performance in any single investment. For example, if one asset performs poorly, the gains in others can help offset those losses, leading to a more stable overall portfolio return.

This strategy is based on the principle that different assets often react differently to market conditions. By not "putting all your eggs in one basket," investors are less vulnerable to significant downturns that can occur in specific sectors or companies. As a result, diversification tends to lower the overall volatility of the portfolio and reduces the likelihood of experiencing extreme losses, thus effectively managing investment risk.

The other options do not accurately reflect the role of diversification in risk management. Some may suggest that it increases risk or has no effect, which overlooks the well-established benefits that come from a diversified approach in investment theory and practice.