Consider the second example above of a mutual fund. Suppose that the mutual fund invests the funds received from investors in the stock of a large number of companies. By doing so, the mutual fund diversifies and reduces its risk. Investors with a small sum to invest would find it difficult to achieve the same degree of diversification because of their lack of sufficient funds to buy shares of a large number of companies. Yet by investing in the mutual fund for the same dollar investment, investors can achieve this diversification, thereby reducing risk.
This economic function performed by financial intermediaries of transforming more risky assets into less risky ones is called diversification. Although individual investors with sufficient funds can achieve diversification on their own, they may not be able to accomplish it as cost effectively as financial intermediaries. Realizing cost-effective diversification in order to reduce risk by purchasing the financial assets of a financial intermediary is an important economic benefit for financial systems.