What is the primary benefit of diversification?

• A. Diversification eliminates market risk.
• B. Diversification reduces debt risk.
• C. Diversification spreads investments across assets with imperfectly correlated returns, reducing unsystematic risk.
• D. Diversification guarantees higher returns.

Answer: (C)

Diversification works by spreading investments across assets whose returns don’t move together perfectly. The main idea is to cut unsystematic risk—the risk tied to individual securities or sectors. When some investments stumble while others rise, their movements offset each other, reducing the portfolio’s overall volatility. However, there’s still systematic risk—the risk that comes from broad market factors that affect almost all assets—so diversification can’t eliminate that. It also doesn’t guarantee higher returns, and it doesn’t specifically address debt risk tied to an issuer’s credit strength. So the strongest benefit is reducing unsystematic risk by mixing assets with imperfectly correlated returns.