What is portfolio diversification?

Portfolio diversification refers to the strategy of spreading investments across a variety of financial instruments, asset classes, or sectors to minimize risk. The fundamental principle behind this approach is that different assets often react differently under various market conditions. By diversifying a portfolio, an investor can reduce the impact of poor performance from any single investment, as losses in one area may be offset by gains in another.

For instance, if an investor has all their capital concentrated in a single stock or a specific type of asset, any adverse event affecting that stock or asset can significantly impact the overall portfolio. Conversely, by holding different types of investments—such as stocks, bonds, real estate, and commodities—an investor can mitigate risk because these assets do not usually move in tandem.

This concept is crucial in finance as it aligns with the goal of preserving capital and achieving sustainable growth over time, making the approach presented in option B the accurate definition of portfolio diversification.