Managing risk is important. Every day we use tools like seat belts and helmets to manage the inherent risks arising from daily activities like driving a car or riding a bike. Managing risk does not guarantee a positive outcome, but statistically and historically speaking, those who use the tools available to them to reduce risk have a better chance of achieving a positive outcome during adverse circumstances.

Financial risk management is not much different, and diversification is one of the most efficient tools available to investors to manage risk. To understand diversification and why it can be beneficial, it's important to understand the inherent risks of investing. One can generally break investment risk into two major categories (both related to uncertainty in the future):

What is Diversification And How Does it Work?

In its simplest form, diversification is akin to the adage, “don't put all of your eggs in one basket.” In practice, diversification means owning a variety of asset classes, including those that are out of favor.

If we adjust the adage to “don't put all of your fruit in one basket”, the analogy becomes more appropriate for holistic portfolio management. We can think of a portfolio as a fruit stand. It would be prudent to sell a variety of fruits instead of just one. If a large unforeseen event like a hurricane wipes out the orange groves in Florida, it would be helpful if you also sold apples from the Northeast or bananas from Hawaii.