What role does diversification play in risk management in investing?

Diversification plays a crucial role in risk management by limiting exposure to any single asset, thereby reducing overall portfolio risk. When an investor diversifies their portfolio, they spread their investments across a variety of asset classes, sectors, or geographical regions. This means that if one particular investment underperforms, the negative impact on the overall portfolio is mitigated by the performance of other investments. As a result, the overall risk associated with the portfolio is reduced.

This approach is based on the principle that different assets often behave differently in varying market conditions. Some assets may perform well when others falter, and by having a mix, an investor can potentially smooth out returns over time. Diversification effectively helps to protect against the volatility of a single investment, leading to a more stable overall return profile.

In contrast, other options either suggest an increase in risk or do not capture the essence of the benefits that a diversified approach confers. For instance, ensuring that all assets have equal performance is unrealistic in investing, as different assets will have varying returns based on market conditions. Similarly, restricting investment options to high-risk assets would contradict the fundamental principle of diversification, which aims to balance risk across a portfolio.