Which of the following statements about diversification are true? Select one or more correct answers.
None of these choices is correct.
A highly diversified portfolio, such as the S&P500, eliminates most of the systematic risk.
There is a limit to the benefits of diversification because of asset-specific risk.
As you increase the number of assets you hold, the marginal benefits of diversification are positive but diminish.
To benefit from diversification you have to put assets together that don’t move alike.
Diversification is difficult and costly.
The Correct Answer and Explanation is:
Correct Answers:
- ✅ There is a limit to the benefits of diversification because of asset-specific risk.
- ✅ As you increase the number of assets you hold, the marginal benefits of diversification are positive but diminish.
- ✅ To benefit from diversification you have to put assets together that don’t move alike.
Explanation (300+ words):
Diversification is a fundamental principle in investment that involves spreading investments across a variety of assets to reduce exposure to any single asset or risk. The goal is to manage risk more effectively by combining different investments that respond differently to the same economic events.
Let’s examine the correct choices:
- “There is a limit to the benefits of diversification because of asset-specific risk.”
This is true. Asset-specific risk, also called unsystematic risk, refers to the risk inherent in an individual asset, like a particular company’s stock. Diversification helps reduce this risk. However, systematic risk (market-wide risk) such as economic recessions, interest rate changes, or geopolitical events cannot be eliminated through diversification. So while diversifying can significantly reduce unsystematic risk, it cannot completely eliminate risk from an investment portfolio. - “As you increase the number of assets you hold, the marginal benefits of diversification are positive but diminish.”
This is true. Initially, adding more assets to a portfolio provides substantial risk-reduction benefits. But after a certain point, the benefits start to diminish — each additional asset contributes less to reducing overall portfolio risk. This concept is known as diminishing marginal returns of diversification. - “To benefit from diversification you have to put assets together that don’t move alike.”
This is true and one of the key concepts of effective diversification. By combining assets that have low or negative correlations with each other (e.g., stocks and bonds), you can ensure that when one asset performs poorly, another may perform well, stabilizing returns over time.
Incorrect Choices:
- ❌ “A highly diversified portfolio, such as the S&P 500, eliminates most of the systematic risk.”
This is false. Diversification can reduce unsystematic risk, but systematic risk remains — even in portfolios like the S&P 500, which includes 500 large-cap U.S. companies. - ❌ “Diversification is difficult and costly.”
This is generally false in modern investing. Today, diversification is easier and cheaper through mutual funds and ETFs, which offer built-in diversification at low cost. - ❌ “None of these choices is correct.”
This is false because several of the provided statements are indeed correct.
In conclusion, diversification is essential for managing risk, but it has limitations. Proper diversification involves selecting assets with different risk-return profiles and low correlation to maximize the benefits.