Answered

Why does diversification primarily reduce unsystematic risk?



a.) Because it leads to higher returns in every scenario

b.) Because individual asset-specific risks can offset each other when combined

c.) Because it prevents systematic risk from affecting the portfolio

d.) Because it removes all market-related risks

Verified Answer :

Final answer:

Diversification reduces unsystematic risk because it allows individual asset-specific risks to offset each other when combined in a portfolio. This strategy stabilizes returns and mitigates the negative impact of a single investment's poor performance. However, it does not eliminate systematic risk that affects the entire market.


Explanation:

Understanding Diversification and Unsystematic Risk

Diversification is a strategy used in investing to reduce risk, particularly unsystematic risk, which is the risk associated with individual assets. Unsystematic risk can result from factors such as a company's performance, management decisions, or industry conditions. By combining different assets into a portfolio, the potential negative impact of an individual asset's poor performance can be balanced out by the positive performance of others.

Why Diversification Reduces Unsystematic Risk?

The correct answer to the question is: b.) Because individual asset-specific risks can offset each other when combined. Here’s why:

  • Asset-Specific Risks: These risks are unique to a particular company or industry. For example, if a technology company faces a setback, it may perform poorly while a healthcare company might be thriving. Holding both can mitigate the overall impact on your portfolio.
  • Combining Assets: By investing in various sectors or asset classes (like stocks, bonds, and real estate), the overall portfolio becomes less vulnerable to the fluctuations of any single investment.
  • Reduction of Volatility: When assets that do not closely move together in price are added to a portfolio, their individual movements can cancel each other out, leading to more stable returns.

However, diversification does not eliminate systematic risk, which is the risk inherent to the entire market, such as economic recessions or political instability. Even a well-diversified portfolio can be affected by these broader market changes.


Learn more about Diversification in Investing here:

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