In financial terms, diversification involves spreading your investments across a variety of assets to reduce the overall risk of your portfolio. In simpler terms, diversification essentially is that old notion of not putting all of your eggs in one basket. Diversification reduces your risk in a couple of ways.

First, in a well diversified portfolio, each individual asset will represent only a small portion of your total wealth. So if one investment goes bad, it only has a small effect on your overall wealth. For example, if you owned only one stock, say Enron, and Enron happened to go to bankrupt, you would have lost everything. On the other hand, if you had spread your investments over 10 stocks, and Enron went bankrupt, you’d only have lost 10 percent of your wealth. Again, don’t put all of your eggs in one basket.

Second, as long as the assets you add to your portfolio are not perfectly correlated, the risk of your portfolio will be less than the average risks of the assets in your portfolio, and the risk will decline as you add more assets. Without getting into the mathematics of this, the basic idea is that gains in some assets will offset losses in others. An important point here is that the less the assets you hold move together, the safer your portfolio will be.

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