How does diversification specifically affect risk in a portfolio?

How does diversification specifically affect risk in a portfolio?

• A. It eliminates all types of risk
• B. It mitigates systematic risk but not specific risk
• C. It reduces specific risk tied to individual assets
• D. It increases overall market risk exposure

Answer: (C)

Diversification reduces specific risk tied to individual assets by spreading investments across a variety of assets or asset classes. When a portfolio includes different types of investments—such as stocks from various sectors, bonds, real estate, and other assets—the impact of any single asset's poor performance on the overall portfolio is diminished. This is because the performance of different assets often does not move in tandem; while one asset may decline in value, another may increase or remain stable. Thus, by holding a diversified portfolio, investors can reduce the impact of risks that are unique to individual assets or investments (known as unsystematic risk), such as business management decisions, market changes specific to a sector, or economic downturns affecting a particular industry. On the other hand, systematic risk, which is related to broader economic factors that affect the entire market, such as interest rates or inflation, cannot be eliminated through diversification. Hence, while diversification improves the overall risk profile of a portfolio by minimizing unique risks, it does not eliminate all risks or address those that are market-wide. This understanding is crucial for private wealth management, as it helps in constructing portfolios that align with investors' risk tolerance and investment objectives while emphasizing the importance of asset allocation and risk management strategies.

Diversification reduces specific risk tied to individual assets by spreading investments across a variety of assets or asset classes. When a portfolio includes different types of investments—such as stocks from various sectors, bonds, real estate, and other assets—the impact of any single asset's poor performance on the overall portfolio is diminished. This is because the performance of different assets often does not move in tandem; while one asset may decline in value, another may increase or remain stable.

Thus, by holding a diversified portfolio, investors can reduce the impact of risks that are unique to individual assets or investments (known as unsystematic risk), such as business management decisions, market changes specific to a sector, or economic downturns affecting a particular industry.

On the other hand, systematic risk, which is related to broader economic factors that affect the entire market, such as interest rates or inflation, cannot be eliminated through diversification. Hence, while diversification improves the overall risk profile of a portfolio by minimizing unique risks, it does not eliminate all risks or address those that are market-wide.

This understanding is crucial for private wealth management, as it helps in constructing portfolios that align with investors' risk tolerance and investment objectives while emphasizing the importance of asset allocation and risk management strategies.