How does diversification reduce risk in a portfolio?

• A. By concentrating investments in a single asset class.
• B. By spreading investments across asset classes and sectors to avoid heavy losses from a single event.
• C. By guaranteeing high returns.
• D. By avoiding any exposure to market risk.

Answer: (B)

Diversification reduces risk by spreading investments across different asset classes and sectors so a single event won’t disproportionately hurt the whole portfolio. The idea is to mix assets that don’t move in perfect unison, so when one part of the market falters, others may hold up or even rise, cushioning overall returns. This targets unsystematic risk—the kind tied to individual investments—which diversification can significantly reduce. However, diversification can’t eliminate market-wide risk (systematic risk) that affects many asset classes at once.

For example, if you owned only one stock, bad news specific to that company could wipe out your gains. A diversified mix—stocks, bonds, real estate, and other assets—helps smooth results because not all of them tend to slump at the same time.

Choosing to concentrate in a single asset class increases risk, not reduces it. Diversification also doesn’t guarantee high returns, and it doesn’t avoid market risk altogether.