Business Degree Certification Practice Test

What does the principle of diversification emphasize?

1. Investing in two or three stocks minimizes risk.

2. Diversification eliminates all types of financial risk.

3. Spreading investments across diverse assets can reduce total risk.

4. Investing heavily in one industry secures higher returns.

The correct answer is: Spreading investments across diverse assets can reduce total risk.

The principle of diversification emphasizes the strategy of spreading investments across a wide range of different assets, such as stocks, bonds, and real estate, to reduce the overall risk of an investment portfolio. By not putting all financial resources into a single investment or type of asset, investors can mitigate the impact of poor performance from any one investment. This is because different assets often react differently to market conditions; when one asset class underperforms, others may perform well, thereby balancing the overall risk. This approach can help maintain a more stable portfolio performance over time, as the losses in one investment may be offset by gains in another. Diversification is fundamental in portfolio management and is widely accepted as a best practice among investors seeking to manage risk effectively without necessarily sacrificing potential returns. In contrast, investing in only two or three stocks may still expose the investor to significant risk, as those stocks may be closely correlated or react similarly to market forces. The idea that diversification eliminates all types of financial risk is misleading, as it cannot eliminate systemic risk that affects the entire market. Lastly, the notion of investing heavily in one industry may promise high returns but simultaneously carries the risk of substantial losses if that industry faces downturns or challenges. Thus, spreading investments across diverse assets is a