What Diversification Is
It is rare to find rational investors concentrating their entire wealth in a single security or investment. Instead, they tend to invest in a diversified portfolio of securities. The reason is that pooling imperfectly correlated stocks together helps to diversify away diversifiable (unique or non-systematic) risks. It has been found that risk of a portfolio is less than the sum of the risks of the individual stocks within the portfolio.
When security returns have perfect positive correlation, the returns of the securities in the portfolio move in the same direction. Therefore, it is not possible to reduce risk without sacrificing some returns. When securities returns have perfect negative correlation, returns always move in different directions. Therefore, the portfolio may contain too risky stocks, but the portfolio may not be risky at all. This is because a fall in the return of one stock will be compensated for by a rise in the return of the other. The more negative the correlation, the higher the possibility of risk reduction.
Diversification is the process of combining securities or investments in a portfolio with the aim of reducing total risks (market risk plus unique risk) without sacrificing portfolio return. It is a form of corporate strategy whereby a company seeks to increase profitability through greater sales volume obtained from new products and/ or new markets.