What does the term "diversification" mean in investment?

The term "diversification" in investment refers to the strategy of spreading investments across various assets or asset classes to reduce risk. By diversifying a portfolio, an investor aims to mitigate the potential impact of a poor performance by any single investment. The rationale behind diversification is that different assets often react differently to the same economic events. For example, while stocks may perform well in a strong economy, bonds may provide stability during downturns. This balance helps to stabilize returns and lower the overall volatility of an investment portfolio.

Focusing investments in one asset class, like stocks or bonds, increases exposure to specific market risks, which can lead to significant losses if that asset class performs poorly. Similarly, investing only in government bonds can limit growth potential, as these tend to yield lower returns compared to other investments. Committing solely to high-risk securities further heightens the risk of substantial losses, rather than achieving a balanced and sustainable investment strategy.

Thus, spreading investments across various assets is a fundamental approach in modern portfolio theory, aiming for an optimal mix that aligns with the investor's risk tolerance and financial goals.