How does diversification help manage investment risk?

Diversification is a fundamental investment strategy designed to manage risk effectively. By spreading investments across a variety of asset classes, sectors, or geographical regions, an investor can reduce the overall impact of any single asset's poor performance on their portfolio. This means that if one asset performs poorly, the losses can be offset by the gains from other assets that may perform well, thereby smoothing out the overall returns.

This strategy is based on the principle that different assets often react differently to the same event or market conditions. For instance, if stocks are underperforming due to economic downturns, bonds or real estate investments might not be as adversely affected and could even thrive under such conditions. Hence, diversification acts as a buffer, protecting the investor from substantial losses that could occur from being overly concentrated in one area.

In contrast, concentrating investments in one asset class, investing only in high-risk ventures, or attempting to time the market strategically can increase the exposure to risks. These approaches can lead to significant volatility and potential losses, as all investments may decline simultaneously due to market or economic conditions. Therefore, diversification is a prudent strategy for risk management in investing.