Which statement best describes diversification across asset classes?

• A. Diversification across asset classes reduces risk.
• B. Diversification increases risk.
• C. Diversification has no effect on risk.
• D. Diversification guarantees profits.

Answer: (A)

Diversification across asset classes reduces risk by combining investments whose prices don’t move in perfect lockstep. When one asset class declines, another may hold up or fall less, which smooths overall portfolio returns and lowers volatility compared with concentrating in a single asset. This principle relies on the different drivers behind each asset class—stocks, bonds, cash, real estate, commodities—so they don’t all respond the same way to the same economic events. Importantly, diversification does not guarantee profits and cannot eliminate risk entirely; in extreme market conditions, correlations can rise and diversification benefits diminish, but the typical outcome is a lower overall risk than a non-diversified approach.