Which statement best describes diversification effect?

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Multiple Choice

Which statement best describes diversification effect?

Diversification reduces risk for a given level of return. The idea is to combine assets whose returns don’t move perfectly in step with each other. When they don’t move together, some of the ups and downs offset, lowering the overall portfolio volatility (risk) without changing the expected return, which is still the weighted average of the individual asset returns. This reduction applies mainly to unsystematic (asset-specific) risk, while systematic (market-wide) risk remains. Because of that, diversification doesn’t guarantee higher returns, nor does it eliminate all risk or routinely reduce the expected return.

Diversification reduces risk for a given level of return. The idea is to combine assets whose returns don’t move perfectly in step with each other. When they don’t move together, some of the ups and downs offset, lowering the overall portfolio volatility (risk) without changing the expected return, which is still the weighted average of the individual asset returns. This reduction applies mainly to unsystematic (asset-specific) risk, while systematic (market-wide) risk remains. Because of that, diversification doesn’t guarantee higher returns, nor does it eliminate all risk or routinely reduce the expected return.

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