Diversification across asset classes reduces which type of risk?

Diversification across asset classes reduces which type of risk?

• A. Systematic risk
• B. Unsystematic risk
• C. Liquidity risk
• D. Credit risk

Answer: (B)

Diversification across asset classes primarily targets risk that is idiosyncratic to individual investments. By spreading across stocks, bonds, real estate, and commodities, the specific problems that could hurt one asset—like a company scandal, a poor earnings report, or a sector-specific slump—don’t affect every asset in the portfolio in the same way. This smoothing of returns lowers the portfolio’s overall variability from those unique, invest­ment-level factors. But broad market movements impact many asset classes at once, so systematic risk remains and can’t be eliminated just by diversification. Liquidity risk and credit risk relate to how easily assets can be traded or the likelihood of issuer default and aren’t the primary target of diversification across asset classes, though diversification can influence them to some extent. The key idea is that unsystematic risk is the part diversification most effectively reduces.

Diversification across asset classes primarily targets risk that is idiosyncratic to individual investments. By spreading across stocks, bonds, real estate, and commodities, the specific problems that could hurt one asset—like a company scandal, a poor earnings report, or a sector-specific slump—don’t affect every asset in the portfolio in the same way. This smoothing of returns lowers the portfolio’s overall variability from those unique, invest­ment-level factors.

But broad market movements impact many asset classes at once, so systematic risk remains and can’t be eliminated just by diversification. Liquidity risk and credit risk relate to how easily assets can be traded or the likelihood of issuer default and aren’t the primary target of diversification across asset classes, though diversification can influence them to some extent. The key idea is that unsystematic risk is the part diversification most effectively reduces.