What is diversification?
Diversification is the practice of spreading money across different investments and asset categories so that a loss in any single holding does not sink an entire portfolio. The 
Securities and Exchange Commission describes it as a core strategy for managing, though not eliminating, investment risk. It works alongside asset allocation and periodic rebalancing as one of the three basic tools investors use to control how much risk their portfolio carries. Diversification does not guarantee a profit or protect fully against loss in a declining market, but it can reduce concentration risk and smooth out returns over time, according to 
Investor.gov.
How diversification works
Diversification means holding a mix of investments so that the fortunes of any one company, industry, or asset class do not determine the fate of the whole portfolio. Investor.gov explains that investors can diversify both across asset classes, such as stocks, bonds, and cash, and within a single asset class, such as holding stocks from different companies, industries, and regions rather than concentrating in one sector. The SEC's Beginners' Guide to Asset Allocation, Diversification, and Rebalancing notes that this approach spreads the money among investments that may react differently to the same market or economic event, so that when one holding falls, another may hold steady or rise. The guide is explicit that diversification "cannot guarantee that you won't suffer a loss," particularly in a broad market downturn that affects most asset categories at once.
Diversification versus asset allocation
Diversification is related to, but distinct from, asset allocation. Asset allocation is the decision about how to divide a portfolio among broad categories like stocks, bonds, and cash based on an investor's time horizon and risk tolerance, according to Investor.gov. Diversification then operates inside and across those categories, spreading holdings among different investments so that a single company's or sector's setback does not disproportionately hurt the portfolio. The SEC notes that stocks have historically carried the highest risk and potential returns, bonds tend to be less volatile with more modest returns, and cash equivalents carry the lowest risk and return but expose investors to inflation risk. Because these categories often behave differently under the same conditions, combining them is part of how diversification reduces overall portfolio volatility.
Diversifying through funds
Mutual funds and exchange-traded funds can offer investors built-in diversification because they typically hold many different securities within a single investment, according to Investor.gov. That guide cautions, however, that a fund focused narrowly on a particular industry or region does not by itself guarantee adequate diversification, and that fees and expenses charged by a fund will reduce an investor's overall returns regardless of how diversified the fund is. Some investors add international exposure as another layer of diversification. Investor.gov's page on international investing notes that investing abroad, through vehicles like American Depositary Receipts or U.S.-registered international funds, may provide diversification across foreign and domestic companies and exposure to growth in other economies, though it carries its own risks, including currency fluctuations, political and economic events, and lower liquidity in some markets.
Diversification and rebalancing over time
A diversified portfolio does not stay fixed; market movements shift the weight of each holding over time, which is why the SEC and Investor.gov both describe rebalancing as a companion practice to diversification. Rebalancing means periodically buying or selling holdings, or directing new contributions, to bring a portfolio back toward its intended mix, for example trimming a stock allocation that has grown from 60 percent to 80 percent of the portfolio. Some investors use "lifecycle" or target-date funds, which automatically shift toward a more conservative mix as a target date approaches, as one way to keep a diversified allocation aligned with a changing time horizon. Investors should also weigh transaction costs and tax consequences before rebalancing, and reassess their allocation whenever their goals, risk tolerance, or financial situation change.
Limits of diversification
Diversification reduces certain kinds of risk but does not remove risk altogether. All investments carry the possibility of loss, including loss of principal, and diversification cannot protect a portfolio from a downturn that affects most asset categories simultaneously, as the SEC makes clear. Separately, deposit and investment protections such as FDIC insurance cover eligible bank deposits up to $250,000 per depositor per insured bank, and the Securities Investor Protection Corporation can replace missing securities and cash at a failed brokerage up to certain limits, but neither protects against ordinary market losses in a diversified or undiversified portfolio. Investors weighing how to diversify their own holdings can review the SEC's Beginners' Guide to Asset Allocation, Diversification, and Rebalancing and Investor.gov's asset allocation and diversification page for further detail on building and adjusting a portfolio to match their own time horizon and risk tolerance.