Diversification primarily reduces which type of risk?

• A. Unsystematic risk
• B. Systematic risk
• C. Market risk
• D. Inflation risk

Answer: (A)

Diversification primarily reduces the risk tied to individual assets, the kind that comes from company-specific events. By spreading investments across many different securities, the positive or negative moves of one security are less likely to drive the whole portfolio, so the variability caused by factors unique to a single company tends to cancel out. This is known as unsystematic risk, the portion of overall risk that diversification can eliminate as you add more diverse holdings.

In contrast, market-wide factors—things like overall economic downturns, interest rate shifts, or inflation—affect nearly all assets. This systematic risk cannot be eliminated simply by holding more stocks or bonds, which is why diversification can reduce only the non-systematic portion of risk.