What is the best strategy for diversifying risk in a portfolio?

Diversifying risk in a portfolio is best achieved by adding uncorrelated assets. When assets within a portfolio are uncorrelated, it means their returns do not move in tandem with each other. This characteristic is crucial because, if one asset class experiences a downturn, the other asset class may remain stable or even perform well, effectively cushioning the overall impact on the portfolio.

The principle behind this strategy is rooted in the idea of reducing volatility and overall risk. By spreading investments across various asset classes, such as stocks, bonds, real estate, or commodities, investors can lessen the likelihood that a decline in one area will significantly harm their overall portfolio. This approach acknowledges that market conditions can vary, and correlations between asset classes can shift over time, reinforcing the importance of careful selection to optimize risk management.

In contrast, adding correlated assets would not provide any significant advantage in risk reduction, as their movements are aligned; thus, they would likely exacerbate losses during market downturns. Investing in a single asset class limits diversity, making the portfolio more susceptible to sector-specific or market-specific risks. Focusing exclusively on high-risk investments increases the potential for large losses, which contradicts the goal of risk diversification.