Updated: Jul 4, 2021
Diversification, at its core, involves not being overly exposed to any single specific risk. Maintaining diversification reduces overall risk but also requires more maintenance and oversight. It also usually means giving up on extreme outcomes, both positive and negative.
The benefit of diversification is a lower risk of ruinous outcomes. While the success of any individual investment will wax and wane in unpredictable ways, diversifying across many asset classes generates a more consistent upside without the chance of any single terrible outcome ruining you by itself. It’s a way of protecting against extreme downside risk. For example, emerging markets stocks can have very high returns, but also have a risk of large losses. If you mix emerging markets with lower risk holdings like U.S. stocks, you can enjoy some of the upside, while limiting your downside.
In essence, diversification is about ensuring steady moderate outcomes rather than risking an all-or-nothing outcome that could ruin you. A diversified portfolio will never out-perform all of the different asset classes that it includes it will always be the average of them. Over time, the lower risk but equal average benefit from diversification is a powerful engine for wealth growth.