What is diversification in an investment portfolio intended to do?

• A. Concentrate investments in a single asset to maximize returns
• B. Avoid all risk entirely
• C. Increase liquidity by selecting only cash equivalents
• D. Spread investments across asset classes to reduce unsystematic risk

Answer: (D)

Diversification aims to reduce unsystematic risk by spreading investments across different asset classes and securities that don’t move in perfect tandem. When you mix assets like stocks, bonds, real estate, and international investments, their price movements don’t align perfectly. If one area falls, another may hold steady or rise, helping to smooth the overall portfolio performance and lower volatility.

This is why spreading across asset classes is the best choice: it targets the risk specific to individual investments or sectors, which can be mitigated through variety. At the same time, diversification doesn’t eliminate all risk—the market can move down across many assets at once (systematic risk), so losses can still occur.

Why the other ideas aren’t right: concentrating in a single asset concentrates risk rather than reducing it; trying to avoid all risk isn’t feasible, as some risk is inherent in investing; and focusing only on cash equivalents improves liquidity but doesn’t achieve diversification, which is about mixing different asset types to manage risk.