Mutual funds and ETFs can provide diversification in a few key ways:

• Holding a broad mix of stocks/bonds – Funds typically invest in dozens or hundreds of different stocks across various sectors, industries, market caps, etc. This provides wide exposure.
• Investing across asset classes – Funds may hold stocks, bonds, real estate, commodities, etc. This diversifies risk across different asset types.
• Varying underlying holdings – Actively managed mutual funds adjust their holdings frequently. Index funds rebalance to match their benchmark. This rotates in different assets.
• Regional/country diversification – Funds may invest globally across companies based in different countries and geographic regions. This reduces concentration in one market.
• Blending investment styles – Some funds use a blend of value, growth or other investment philosophies to diversify stylistic risk.
• Offering balanced/target date funds – These funds hold preset mixes of stocks and bonds tailored to an investor’s risk tolerance or retirement date. Built-in diversification.

The bottom line is that mutual funds and ETFs allow an investor to gain much wider diversification than they could typically achieve just buying individual stocks and bonds on their own. This spreads out and reduces portfolio risk.