Diversification primarily helps mitigate which type of risk?

• A. Systematic risk can be eliminated by diversification.
• B. Diversification eliminates market risk entirely.
• C. Idiosyncratic risk can be diversified away.
• D. Diversification increases portfolio risk.

Answer: (C)

Diversification mainly targets risk that comes from individual investments rather than overall market movements. When you hold a broad mix of assets, the unique factors affecting any one security—like a company-specific setback, a product failure, or a management change—tend to offset each other, reducing the portfolio’s overall volatility. This is idiosyncratic (unsystematic) risk, and it can be mitigated or even eliminated by spreading investments across many securities and sectors.

In contrast, risk that arises from broad market factors—economic cycles, interest rates, geopolitical events—affects many assets at once and cannot be removed just by adding more securities. That is systematic risk, which diversification cannot eliminate, though it can be tempered somewhat byasset allocation and other strategies.

So, diversification’s primary benefit is reducing idiosyncratic risk.