Define diversification and its role in reducing risk.

Define diversification and its role in reducing risk.

• A. Spreading investments across different asset classes and securities to reduce unsystematic risk and smooth returns.
• B. Concentrating investments in a single asset class.
• C. Ignoring risk to maximize returns.
• D. Diversification increases systematic risk.

Answer: (A)

Diversification is spreading investments across different asset classes and securities to reduce unsystematic risk and smooth returns. By combining assets that don’t move in perfect sync, the negative performance of one investment can be offset by another, lowering overall portfolio volatility and helping you pursue long-term goals with more stability. This approach targets company- or security-specific risks, not market-wide risks that affect all investments. Concentrating in a single asset class increases risk because it ties your fate to that class’s performance. Ignoring risk to chase higher returns contradicts the purpose of diversification, which is to manage risk. And diversification doesn’t raise market-wide (systematic) risk; it can’t eliminate it, but it mainly reduces the risk tied to individual investments.

Diversification is spreading investments across different asset classes and securities to reduce unsystematic risk and smooth returns. By combining assets that don’t move in perfect sync, the negative performance of one investment can be offset by another, lowering overall portfolio volatility and helping you pursue long-term goals with more stability. This approach targets company- or security-specific risks, not market-wide risks that affect all investments.

Concentrating in a single asset class increases risk because it ties your fate to that class’s performance. Ignoring risk to chase higher returns contradicts the purpose of diversification, which is to manage risk. And diversification doesn’t raise market-wide (systematic) risk; it can’t eliminate it, but it mainly reduces the risk tied to individual investments.