If you wish to create a portfolio of stocks to reduce your investment risk, which of the following strategies is most effective?

• A. Invest only in stocks from the same industry.
• B. Invest all your funds in a single high-performing stock.
• C. Invest in stocks with the highest recent returns regardless of industry.
• D. Invest in a variety of stocks from different industries and sectors.

Answer: (D)

Verified step by step guidance

1. Understand the concept of diversification: Diversification is a risk management strategy that involves spreading investments across various financial assets, industries, or sectors to reduce exposure to any single asset or risk.
2. Analyze why investing in stocks from the same industry is not effective: Stocks within the same industry are likely to be affected by similar economic, regulatory, or market conditions, which increases the risk of portfolio losses if that industry faces challenges.
3. Evaluate the risk of investing all funds in a single high-performing stock: While a single stock may show high returns temporarily, it exposes the investor to significant risk if the stock's performance declines due to company-specific issues or market volatility.
4. Consider the limitation of investing in stocks with the highest recent returns: High recent returns do not guarantee future performance, and focusing solely on past returns without considering diversification can lead to increased risk.
5. Conclude that investing in a variety of stocks from different industries and sectors is the most effective strategy: This approach reduces the impact of poor performance in any single industry or sector, thereby lowering overall investment risk and increasing the potential for stable returns.