In the context of financial markets, diversification refers to allocating capital to different financial instruments within and across asset classes. The main goal is to reduce the overall risks that may arise from holding a single asset class, such as a stock, bond, commodity, or cryptocurrency.
The idea behind the diversification strategy is that a portfolio made of a wide variety of assets is more likely to give better long-term returns, while also reducing the probability of significant losses. Diversification can be achieved within a single asset class (e.g., investing in different types of cryptocurrencies) or across various asset classes (e.g., investing in cryptocurrencies, stocks, and commodities).
Other than that, diversification strategies may also take into account other factors such as the asset’s geographic location, industry niche, company size, and so forth. For example, holding stocks from companies that are located in different countries will generate a higher degree of diversification than holding a variety of US-based stock shares.
People usually say that an investor should never “put all their eggs in one basket,” and this popular expression represents very well the logic of diversification. Although holding multiple baskets may incur higher costs and increased risk of losing one egg, it greatly reduces the chances of losing them all. Conversely, diversification limits upside potential as a single asset can exhibit higher positive returns.