What is a key trade-off of diversification?

The key trade-off of diversification is that it leads to a reduction of risk but can also result in potentially limited returns. Diversification involves spreading investments across various asset classes or securities, which can help mitigate the impact of poor performance in any single investment. This strategy aims to reduce the overall volatility and risk of a portfolio. However, as the risk is minimized, the potential for extraordinary returns may also be constrained, especially if a significant portion of the portfolio is allocated to lower-risk, lower-return investments.

This concept aligns well with modern portfolio theory, which suggests that a well-diversified portfolio can achieve a more favorable risk-return profile compared to a concentrated investment strategy. While diversification cannot eliminate risk completely, it does help in managing and reducing it. Therefore, while investors can expect steadier performance and reduced risk through diversification, they must also acknowledge the possibility of capping their upside potential in highly aggressive markets.