What effect does diversification have on an investment portfolio?

• A. It guarantees higher returns
• B. It increases exposure to specific asset types
• C. It reduces risk by spreading investments across various assets
• D. It simplifies the investment decision process

Answer: (C)

Diversification has a crucial role in investment strategy, and its primary effect is that it reduces risk by spreading investments across various assets. When an investor diversifies their portfolio, they include a mix of different asset classes, such as stocks, bonds, real estate, and commodities. This distribution helps mitigate the impact of poor performance in any single investment or asset class.

For example, if one sector, such as technology, experiences a downturn, other sectors, like healthcare or utilities, might remain stable or even thrive, balancing the overall risk. By not putting all their eggs in one basket, investors can enhance the stability of their portfolios over time, ultimately leading to smoother returns.

The other options reflect misunderstandings about diversification. For instance, it does not guarantee higher returns; rather, it aims to optimize the risk-return profile. It also does not specifically increase exposure to certain asset types, but rather seeks a balance across multiple types. Lastly, while diversification can lead to a more straightforward overview of risk management, it does not necessarily simplify the investment decision process, as selecting the right mix of assets requires careful research and consideration.