Diversification reduces which type of risk most directly?

• A. Systematic risk
• B. Unsystematic risk
• C. Market risk
• D. Inflation risk

Answer: (B)

Diversification targets risks that come from individual assets. This unsystematic (idiosyncratic) risk arises from factors unique to a single company or investment—things like a product setback, a CEO shake-up, or a strike in a specific industry. By mixing different assets that don’t move in lockstep, the losses from one investment can be offset by others that perform differently, so the portfolio’s overall volatility falls as you add more diverse holdings.

In contrast, risks that affect the whole market or economy—systematic (market) risk such as broad economic downturns, changes in interest rates, or inflation—aren’t removed by diversification. Inflation risk also tends to affect many assets similarly and isn’t eliminated by holding a broader mix. So diversification most directly reduces unsystematic risk.