Which statement best describes the purpose of diversification in risk management?

Which statement best describes the purpose of diversification in risk management?

• A. Diversification concentrates investments in a single asset class to maximize returns.
• B. Diversification spreads risk across different asset classes to reduce overall risk.
• C. Diversification guarantees higher returns.
• D. Diversification eliminates all investment risk.

Answer: (B)

Diversification aims to lower risk by spreading investments across different asset classes whose returns don’t move in lockstep. By combining assets with varying risk drivers, the portfolio’s losses in one area can be offset by gains or smaller losses in another, reducing overall volatility. This reduces unsystematic risk—the risk tied to individual investments—without necessarily sacrificing expected return. It doesn’t guarantee higher returns, and it cannot eliminate market-wide risk that affects all investments. So spreading investments across asset classes to reduce overall risk is the purpose of diversification.

Diversification aims to lower risk by spreading investments across different asset classes whose returns don’t move in lockstep. By combining assets with varying risk drivers, the portfolio’s losses in one area can be offset by gains or smaller losses in another, reducing overall volatility. This reduces unsystematic risk—the risk tied to individual investments—without necessarily sacrificing expected return. It doesn’t guarantee higher returns, and it cannot eliminate market-wide risk that affects all investments. So spreading investments across asset classes to reduce overall risk is the purpose of diversification.