How does diversification help manage risk?

How does diversification help manage risk?

• A. It spreads investments across assets to reduce unsystematic risk.
• B. It concentrates investments in one asset to maximize returns.
• C. It eliminates market risk.
• D. It guarantees profits.

Answer: (A)

Diversification is about spreading investments across different assets so that the impact of any single investment’s poor performance is reduced. This lowers unsystematic risk—the risk tied to a specific company or asset. With a mix of assets that don’t move in perfect lockstep, when one investment falters, others may hold up or grow, smoothing overall returns over time. It can’t remove market risk—the risk that comes from factors affecting the entire economy—as broad downturns can affect many asset classes. It also doesn’t guarantee profits; even a well-diversified portfolio can lose money in a bad market. So spreading investments across assets to reduce unsystematic risk is the best explanation.

Diversification is about spreading investments across different assets so that the impact of any single investment’s poor performance is reduced. This lowers unsystematic risk—the risk tied to a specific company or asset. With a mix of assets that don’t move in perfect lockstep, when one investment falters, others may hold up or grow, smoothing overall returns over time. It can’t remove market risk—the risk that comes from factors affecting the entire economy—as broad downturns can affect many asset classes. It also doesn’t guarantee profits; even a well-diversified portfolio can lose money in a bad market. So spreading investments across assets to reduce unsystematic risk is the best explanation.