Which of the following statements is most correct concerning diversification and risk in the context of accounting and financial reporting?

• A. Diversification reduces unsystematic risk by spreading investments across different assets.
• B. Diversification has no impact on the risk associated with an investment portfolio.
• C. Diversification increases the overall risk of an investment portfolio.
• D. Diversification eliminates all types of risk, including systematic risk.

Answer: (A)

Verified step by step guidance

1. Understand the concept of diversification: Diversification involves spreading investments across various assets or industries to reduce the impact of any single asset's poor performance on the overall portfolio.
2. Differentiate between types of risk: Unsystematic risk (also known as specific or idiosyncratic risk) is unique to a particular company or industry and can be mitigated through diversification. Systematic risk, on the other hand, is market-wide and cannot be eliminated through diversification.
3. Analyze the statement 'Diversification reduces unsystematic risk by spreading investments across different assets': This is correct because diversification minimizes the impact of individual asset volatility, reducing unsystematic risk.
4. Evaluate the statement 'Diversification has no impact on the risk associated with an investment portfolio': This is incorrect because diversification directly reduces unsystematic risk, thereby lowering the overall risk of the portfolio.
5. Assess the statement 'Diversification eliminates all types of risk, including systematic risk': This is incorrect because systematic risk, such as market-wide economic changes, cannot be eliminated through diversification.