Many investors lack the time or the expertise to determine which specific stocks, bonds or other investments they should hold in their portfolio. In addition, they may not have enough money on hand to sufficiently spread out their risk by holding a large number of different securities across sectors, industries and companies.
This spreading out of risk, or diversification, is one of the basic tenets of modern portfolio theory, which holds that you can reduce the risk (volatility) of the overall portfolio by owning a number of securities that tend to move independently of each other. Diversifying, or introducing more securities, helps reduce the overall risk of a portfolio. The fewer securities you hold, the likelier it is that a decline in one of them could adversely affect the whole portfolio; a larger pool of securities tends to spread that risk.
One way to reap the benefits of diversification is through index investing—the practice of investing in a fund with a portfolio of securities that mirrors a particular index.