The principle of diversification tells us that:
A)concentrating an investment in two or three large stocks will eliminate all your risk.
B)concentrating an investment in three companies all within the same industry will greatly reduce your overall risk.
C)spreading an investment across five diverse companies will not lower your overall risk.
D)spreading an investment across many diverse assets will eliminate all the risk.
E)spreading an investment across many diverse assets will eliminate idiosyncratic risk.

Question

Quizplus · Accepted Answer

The principle of diversification tells us that spreading an investment across many diverse assets will eliminate idiosyncratic risk, which is the risk that is unique to a particular asset or company. However, diversification does not eliminate systematic risk, which is the risk that affects the overall market. Therefore, it is important to have a diversified portfolio, but also to be aware of systematic risks that cannot be diversified away. Choices A, B, and C are incorrect because concentrating investments in a few stocks or companies does not eliminate risk, but instead increases the potential for losses if those stocks or companies perform poorly. Choice D is incorrect because diversification does not eliminate all risk.

The Principle of Diversification Tells Us That