What impact does diversification have on a portfolio?

Diversification is a fundamental concept in finance that refers to the strategy of spreading investments across various assets to reduce exposure to any single asset or risk. The correct answer highlights that diversification can reduce risk without sacrificing expected returns.

When investors diversify their portfolios, they combine different types of assets—such as stocks, bonds, real estate, and commodities—those with varying degrees of risk and return. The idea is that when one asset class underperforms, others may perform well, which can balance out the overall performance of the portfolio. This mixture can lead to a more stable and lower risk profile because the negative performance of some investments can be offset by the positive performance of others, thus decreasing volatility and potential losses.

Additionally, while it's possible for diversification to decrease overall expected returns compared to a concentrated portfolio of high-performing assets, well-executed diversification often allows investors to achieve similar returns with less risk. This is particularly advantageous for risk-averse investors who want to protect their capital while still aiming for reasonable growth.

In summary, effective diversification helps to manage risk and smooth out the fluctuations in portfolio returns, making it a crucial strategy for investors seeking to create a balanced investment approach.