which of the following statements about diversification is correct? group of answer choices portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio. if an investor buys enough stocks, he or she can, through diversification, eliminate virtually all of the risk inherent in owning stocks. indeed, if the portfolio contained all publicly traded stocks, it would be riskless. diversifiable risk
The Correct Answer and Explanation is :
The correct statement about diversification from the options given is:
“Portfolio diversification reduces the variability of the returns on the individual stocks held in the portfolio.”
Explanation:
Diversification is a fundamental concept in finance and investment management. It refers to the practice of spreading investments across various financial instruments, industries, and other categories to reduce risk. The primary purpose of diversification is to minimize the impact of any single asset’s poor performance on the overall portfolio.
- Reducing Variability: When an investor holds a diversified portfolio, the overall risk (or variability) of returns is reduced because the individual stock returns do not move perfectly in sync. Some stocks may perform well when others do poorly, which balances out the overall returns. For example, if one sector of the economy is facing challenges, another sector may be thriving, thereby stabilizing the overall portfolio returns.
- Limiting Risk but Not Eliminating It: The assertion that an investor can eliminate virtually all risk through diversification is misleading. While diversification can significantly reduce unsystematic risk (the risk associated with individual stocks), it cannot eliminate systematic risk, which is the inherent risk that affects the entire market or economy (such as interest rate changes or economic downturns). Hence, even a well-diversified portfolio can still experience declines during market downturns.
- Risklessness of a Fully Diversified Portfolio: The claim that a portfolio containing all publicly traded stocks would be riskless is incorrect. Such a portfolio would still be subject to systematic risk, as it would be influenced by market-wide factors.
In conclusion, while diversification is an effective strategy to reduce variability and unsystematic risk, it does not eliminate all risk associated with investing in stocks. Investors must still be aware of the potential for systematic risk that exists within the market.