Final answer:
Diversification becomes more effective when investments are less correlated, mitigating risks by offsetting the performance of different assets. Investors and banks use diversification to spread out risks, but it may not protect against systemic economic downturns.
Step-by-step explanation:
Diversification as a risk-reducing strategy becomes more effective as the correlation among investments is lower. When investments are less correlated, they are less likely to respond to economic events in the same way at the same time. Therefore, if one investment decreases in value, another might increase or remain stable, which reduces the overall risk of the portfolio.
Investing in a single company's stocks or bonds is inherently risky due to factors like supply and demand, managerial decisions, and other unforeseen events. By spreading investments across a broad range of companies, a saver can follow the wisdom of not putting all their eggs in one basket. This strategy of diversifying investments helps mitigate the risk of significant losses because the negative performance of some investments is likely to be offset by the positive performance of others.
Banks also apply diversification strategies to protect against loan defaults and asset-liability time mismatch by distributing loans across various customers, industries, and geographic areas. However, diversification may not offer protection against systemic risks such as a widespread recession that affects multiple industries and regions simultaneously.