Diversification reduces risk by spreading investments across asset classes, industries, and geographies. Why is this effective?

• A. It concentrates investments in one sector.
• B. It reduces the impact of any single investment's poor performance on the overall portfolio.
• C. It eliminates all risk.
• D. It guarantees profits.

Answer: (B)

Diversification reduces risk by spreading investments across different assets, so the portfolio isn’t tied to the fate of a single investment. When asset returns aren’t perfectly correlated, solid performance in some areas can offset weaker results in others, lowering overall volatility. This targets the risk unique to individual investments or sectors, while leaving broader market risk intact. So, spreading across asset classes, industries, and geographies reduces downside impact without guaranteeing profits. Concentrating in one sector increases exposure to its specific risks, and diversification cannot eliminate all risk or guarantee profits.