Which approach is most effective for diversifying risk in a portfolio?

Diversifying risk in a portfolio is best achieved through effective asset allocation across various sectors and regions. This approach minimizes the impact of any single investment's poor performance on the overall portfolio. By investing in different asset classes—such as equities, fixed income, and alternatives—and spreading investments geographically, the portfolio is better positioned to withstand market volatility.

This method benefits from the fact that different sectors and regions often respond differently to economic changes, allowing for a smoother overall performance. Additionally, correlations among assets may vary over time; diversification aims to reduce the risk associated with the uncertainties of specific investments, creating a more balanced risk-return profile overall.

Other strategies, such as concentrating investments in one sector or investing solely in developed markets, can expose the portfolio to greater risk and potential losses, as they do not capture the benefits that come from a well-diversified approach. Reinvesting in higher-risk assets without a balanced allocation may also lead to an increase in volatility and does not effectively mitigate risk.