Question

Financial advisors usually recommend diversified portfolios to reduce risk. Why does diversification reduce risk? Does it eliminate risk? Why or why not? (3-6 sentences)

Answer 1

Diversification is a process of allocating capital in such a way that it reduces the exposure to certain asset and reduces risk. By allocating capital using diversification, it helps you to earn the same amount of return by taking the same level of risk.

Although Diversification does help in reducing risk but it does not eliminate risk. It is because, diversification can only eliminate asset specific risk and not the systematic risk. So, diversification only reduces risk and this also depends on the correlation between different assets.