What does diversification mean in financial terms?

Diversification in financial terms refers to the practice of spreading investments across different assets to reduce risk. By holding a variety of investments that react differently to the same event, an investor can minimize the impact of any single asset's poor performance on their overall portfolio. This strategy is based on the principle that not all assets will respond similarly to market changes, thus lessening volatility and potential losses.

When investments are diversified effectively, the potential gain of some investments can offset the losses of others, creating a more stable return over time. This approach is fundamental in portfolio management, as it helps investors achieve a balance between risk and return.

In contrast to diversification, concentrating investments in one asset can expose an investor to a higher level of risk, as the performance of the portfolio becomes heavily dependent on that single asset. Similarly, liquidation of non-performing assets focuses on selling underperforming investments rather than spreading capital across a range of different investments, which does not align with the principles of diversification. Finally, acquiring similar companies to reduce competition could lead to a monopoly and does not pertain to the idea of spreading risk across varied assets.