A diversified investment is a portfolio of various assets that earns the highest return for the least risk. A typical diversified portfolio has a mixture of stocks, fixed income, and commodities. Diversification works because these assets react differently to the same economic event.
Stocks do well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.2
Bonds and other fixed income securities do well when the economy slows. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.3
