Final answer:
Diversification is an investment strategy aimed at reducing risk by spreading investments across various entities, industries, asset types, strategies, regions, and time periods. It helps to mitigate the risks associated with single-company investments and other specific risks. Mutual funds are a common tool for achieving diversification.
Step-by-step explanation:
Diversification in Investment Portfolios
Diversification is a strategy that involves spreading investments across a variety of different companies, industries, asset classes, strategies, geographies, and time periods to reduce risk. By not putting all your eggs in one basket, you avoid the potential downfall associated with investing in a single company, which may be prone to unfavorable supply and demand conditions or poor managerial decisions. This investment principle is fundamental to creating a resilient portfolio.
Mutual funds are an example of diversification, as they usually invest in a wide range of stocks or bonds from different companies. When you invest in a mutual fund, you're inherently diversifying your investment and protecting yourself against extreme fluctuations in value.
Beyond individual company risk, other forms of diversification include industry diversification, where investments are spread across different sectors; asset class diversification, involving different types of assets like stocks, bonds, and real estate; strategy diversification, employing various investment tactics; geographic diversification, investing in markets across different countries; and time diversification, spreading investments across various time horizons to hedge against market volatility at any given time.