What is meant by 'risk diversification'?

Risk diversification refers to the strategy of spreading investments across a wide range of assets, sectors, or activities in order to reduce the overall risk associated with an investment portfolio. This concept is grounded in the principle that not all investments will perform poorly at the same time; by diversifying, an investor can minimize the impact of any single underperforming investment on the overall portfolio.

When investments are diversified, the risk is less concentrated in any one investment or asset class. For instance, if one company or sector experiences a downturn, the overall impact on the portfolio may be mitigated by the performance of other investments that are doing well. This reduces volatility and the potential for significant financial loss.

In contrast, concentrating investments in a single asset, investing solely in government bonds, or limiting investments to high-risk assets would not achieve the goal of diversification. Concentration increases risk, while investing only in government bonds or high-risk assets can expose an investor to specific sector or market risks without the safety net that diversification provides. Thus, spreading risk across various investments or activities is a fundamental strategy in risk management and investment practice.