Which statement about diversification and risk is true?

• A. Diversification eliminates all risk.
• B. Diversification increases market risk.
• C. Diversification reduces unsystematic risk, leaving systematic risk; portfolio risk decreases.
• D. Diversification has no impact on risk.

Answer: (C)

Diversification mainly targets the part of risk that comes from factors specific to a single company or industry. By spreading investments across many assets with different drivers, that unsystematic (idiosyncratic) risk shrinks because bad news in one asset can be offset by others doing well. But the risk tied to the overall market—systematic risk—affects nearly all investments and cannot be eliminated simply by holding more assets. As a result, a diversified portfolio tends to have lower total risk than individual holdings, since unsystematic risk is reduced, while systematic risk remains. This is why the statement that diversification reduces unsystematic risk, leaves systematic risk, and lowers portfolio risk is the best description. The other ideas—risk eliminated completely, market risk increasing, or diversification having no impact—don’t align with how diversification works in practice.