What does diversification in a portfolio aim to achieve?

Diversification in a portfolio aims to minimize risk by investing in a variety of unrelated assets. This approach is grounded in the principle that different asset classes and investments often respond differently to market conditions. By holding a mix of assets—such as stocks, bonds, real estate, and commodities—a portfolio can reduce the overall impact of negative performance in any single asset or asset class.

When one investment underperforms, others may perform well, helping to offset potential losses. This strategy is based on the observation that not all investments will move in the same direction at the same time; thus, diversification can smooth out the volatility and contribute to more stable returns over time.

In contrast, maximizing profits through risky investments focuses mainly on individual high-reward opportunities without considering risk management, which can expose a portfolio to significant losses. Concentrating on high-growth sectors or a single type of asset can lead to a lack of balance and increased risk, as these investments may be more susceptible to market fluctuations or downturns. Hence, the correct understanding of diversification is that it seeks to achieve lower risk through a well-rounded and varied investment strategy.