How can diversification impact investment risk?

Diversification is a fundamental investment strategy that involves spreading investments across different asset classes, sectors, or geographical regions. The primary rationale behind this approach is to mitigate risk. By diversifying a portfolio, an investor can reduce the impact of any single asset's poor performance on the overall portfolio. If one investment underperforms, others may perform well, thus balancing out the overall returns.

For example, if an investor holds stocks in various industries, the decline of one sector may be offset by gains in another. This risk reduction occurs because different investments often do not move in tandem; they are influenced by different economic factors. Consequently, diversification can lead to a more stable performance over time, making it a key strategy for managing investment risk effectively.

The other options relate to potential misunderstandings of diversification. While it can introduce complexity in terms of more frequent trading or balancing a portfolio, these factors do not define the essence of what diversification achieves in terms of risk management. The primary benefit remains its capacity to reduce exposure to volatility and adverse performance through a well-balanced investment approach.