What is the aim of diversification in a portfolio?

The aim of diversification in a portfolio is primarily to reduce overall portfolio risk by spreading investments across various asset classes. This strategy works on the principle that different asset classes, such as stocks, bonds, real estate, and commodities, often react differently to the same economic events. By holding a mix of these assets, an investor can mitigate the impact of poor performance from any single investment. When one asset is underperforming, another may be doing well, which helps to smooth out returns over time and lower the overall risk of the portfolio.

Diversification does not guarantee a profit or prevent loss, but it is fundamental to effective risk management. The strategy aims to create a balanced portfolio where the positive performance of some investments can offset losses in others, thus leading to a more stable return profile. This approach acknowledges that while individual assets might be volatile, a well-diversified portfolio can provide a better risk-return balance.

Other options, such as increasing potential returns significantly or concentrating investments, do not align with the primary goal of diversification. Additionally, while simplification of investment strategies can be a secondary benefit, the core purpose remains risk reduction through varied asset allocation.