What effect does diversification typically have on an investment portfolio?

Diversification typically has a significant and beneficial effect on an investment portfolio by spreading investments across various assets, sectors, or geographies. This strategy aims to reduce the overall risk associated with the portfolio without drastically compromising potential returns.

When investors diversify, they minimize the impact that a poor performance from any single investment can have on the total portfolio. For example, if one sector is underperforming, gains in another sector can help offset those losses, leading to a more stable investment outcome. This balance can lead to a more consistent performance over time, as various assets will respond differently to market conditions.

The principle behind this is that while individual investments may carry a certain level of risk, when combined in a diversified manner, the overall portfolio risk can be reduced. Historically, a well-diversified portfolio will typically show lower volatility compared to a concentrated portfolio, which only consists of a few investments. Hence, the statement about diversification leading to reduced risk while maintaining a good potential for returns accurately summarizes its core advantage in portfolio management.