According to the principle of diversification, what happens when an investment is spread across many assets?

Introduction / Context:
The principle of diversification is central to modern portfolio theory and practical investment management. It explains why investors rarely hold a single risky asset and instead build portfolios of many securities. Exam questions often ask what diversification does to risk in order to test understanding of systematic and unsystematic components of total risk. The key idea is that diversification can reduce or eliminate unsystematic risk but cannot remove all risk from investing in risky assets.

Given Data / Assumptions:

• Total risk of an investment can be separated into systematic risk, which affects the whole market, and unsystematic risk, which is specific to individual firms or sectors.
• Investors can hold portfolios containing many different assets.
• Returns on different assets are not perfectly positively correlated.
• Investors are generally risk averse and prefer to reduce risk without sacrificing return when possible.

Concept / Approach:
Diversification involves spreading funds across many different assets, industries and sometimes countries so that negative surprises in some holdings may be offset by better performance in others. This process can substantially reduce unsystematic risk, such as the risk of a particular company experiencing a scandal, strike or product failure. However, systematic risk, such as economy wide recessions or interest rate shocks, affects most assets and cannot be eliminated simply by adding more securities to the portfolio. The correct option must therefore state that spreading investments reduces some of the total risk, not that it removes all risk or that concentration reduces risk.

Step-by-Step Solution:
Step 1: Recall that unsystematic risk is specific to individual companies or industries and can be diversified away by holding many different assets. Step 2: Recognise that systematic risk is common to the whole market and remains even in well diversified portfolios. Step 3: Understand that by holding a broad mix of assets, an investor reduces the impact of any one security poor performance on the overall portfolio. Step 4: Review the options and identify the one that states that diversification eliminates some of the total risk, not all risk. Step 5: Select the option that emphasises spreading investments across many diverse assets to reduce risk from specific securities or issuers.

Verification / Alternative check:
Consider two investors: one holds only a single company stock, while the other holds a diversified portfolio of 30 different stocks in various industries. If that single company experiences a major problem and its stock price falls sharply, the first investor portfolio suffers a large loss. The second investor experiences only a modest impact, because the problem at one company is diluted among many holdings. However, if a broad market downturn occurs, both investors will see negative impacts, although the diversified portfolio may still be less volatile. This example illustrates how diversification reduces unsystematic risk but not systematic risk, confirming the correct statement.

Why Other Options Are Wrong:
Option B is wrong because holding only two or three stocks does not eliminate all unsystematic risk; a much larger and more diverse portfolio is usually needed to significantly reduce firm specific risk. Option C incorrectly claims that diversification does not lower total risk, contradicting well established portfolio theory and evidence. Option D suggests that concentrating in three companies within the same industry will reduce systematic risk, but such concentration actually increases exposure to industry specific shocks. Option E describes holding only a risk free asset, which eliminates risk but also offers lower returns relative to risky assets, and does not relate to the principle of diversification among risky assets.

Common Pitfalls:
A common pitfall is to believe that diversification can completely eliminate all risk from investing in equities or other risky assets. Another mistake is to think that owning a small number of stocks in the same industry counts as true diversification. Some investors also confuse diversification with random selection of securities, ignoring the importance of low correlation among assets. Understanding that diversification primarily reduces unsystematic risk and that systematic risk remains helps investors and exam candidates apply the principle correctly and interpret questions accurately.

Final Answer:
Spreading an investment across many diverse assets will eliminate some of the total risk by reducing exposure to any one specific security or issuer.