What does diversification attempt to reduce in an investment portfolio?

Diversification attempts to reduce unsystematic risk, the company-specific or industry-specific risk associated with individual investments. Holding assets whose returns do not move perfectly together can reduce the effect of one company’s poor result on the overall portfolio.

For example, an investor who owns shares in many industries is less exposed to a single product failure than an investor who owns only one company. Diversification can be achieved across companies, sectors, countries, asset classes, and time periods, although adding investments does not automatically create a well-diversified portfolio.

Diversification cannot remove systematic risk, which affects broad markets. Recessions, major interest-rate changes, widespread financial crises, and other market-wide shocks can influence many assets at once. Diversification also cannot guarantee a profit or prevent losses. The benefit depends on how the holdings respond to one another, not merely on the number of securities held.