What is the purpose of diversification in investing?

The purpose of diversification in investing is to spread investments across various financial vehicles to reduce risk. By holding a diverse portfolio that includes different asset classes—such as stocks, bonds, real estate, and commodities—an investor can mitigate the impact of any single investment's poor performance on their overall portfolio.

For instance, if one sector of the market experiences a downturn, the losses in that sector may be offset by gains in another sector that is performing well. This strategy allows investors to achieve more stable returns over time, rather than experiencing the significant ups and downs that can come from concentrating investments in a limited number of assets. Diversification serves as a risk management tool, enhancing the potential for more consistent performance as it reduces the likelihood of substantial losses.