Canadian Securities Course (CSC) Level 2 Practice Exam

How does diversification help reduce risk in a portfolio according to the text?

1. By investing in similar asset classes

2. By focusing solely on high-risk investments

3. By reducing overall risk of a portfolio without decreasing return

4. By concentrating investments in one sector

The correct answer is: By reducing overall risk of a portfolio without decreasing return

Diversification is a key strategy used in investment management to help reduce risk in a portfolio while aiming to maintain expected returns. The correct answer highlights that diversification reduces the overall risk of a portfolio without necessarily decreasing returns. This is achieved by spreading investments across a range of assets, such as different sectors, geographic regions, and asset classes, which can offset potential losses. When one asset or sector underperforms, the impact on the overall portfolio is minimized, as other investments may perform well. This strategy allows investors to manage risk effectively, making it possible to achieve a more stable performance over time. Investing in similar asset classes or concentrating in one sector does not provide the same protective benefits that diversification offers, as these strategies can lead to increased volatility and risk exposure. Similarly, focusing solely on high-risk investments typically heightens risk rather than mitigates it. Hence, the approach described in the correct answer aligns with the principles of building a balanced and resilient investment portfolio.